There’s an overwhelming belief among the investment public that stock options and derivatives are risky and hard to understand. In general terms, I agree. Many times they are both of these, sometimes to the extreme. But there is one facet of options trading that you’ll definitely want to know about, Covered Calls. The proper execution of an actively managed, covered call strategy has the potential to limit risk while boosting your returns.
I’m struck by how much poor information regarding covered calls is on the internet, even from credible sources. I wrote this article to help you cut through the “fog” of misinformation and provide you with a basic understanding of what covered calls are, how they work, and why they should be an essential tool for almost every investor.
Here’s a simple explanation of a covered call.
Assume you own 100 shares of XYZ. (XYZ is a made-up company.) XYZ is trading at $50 a share.
- You own 100 shares of XYZ @ $50.00 per share.
You can now sell someone the right to buy your 100 shares at $52 a share. You would explain this action by saying that you can now “sell a call option with a strike price of $52”.
You are paid to sell this right. Let’s assume in this example you are paid $2.00 a share (for a total of $200. I’ll just say $2 to keep the math easy). Also, the right will expire at some point in the future. Let’s assume it expires 1 month from today.
- Sell 1 call on XYZ:
Strike Price = 52
Premium = $2
Expiration = 1 month
The right to buy XYZ at $52 can be exercised at any time by the call buyer within the next month. The buyer won’t exercise this right unless the stock price is at or above $52.
The term “covered” call means you already owned the 100 shares of XYZ before the sale of the call. If you didn’t already own the shares, it would be known as a “naked call”. I do not advocate selling “naked calls” as they can be very risky. We’re only taking about selling “covered” calls on stock you already own.
- Your net return in 3 different scenarios
- Price rises to 60 = $2 premium + $2 capital gain = $4
This requires sale of XYZ at 52.
- Price stays at 50 = $2
The call expires worthless. You still own the 100 XYZ.
- Price drops to 40 = $2 – 10 = -$8
The call expires worthless. You still own the 100 XYZ.
You might ask, “Who would want to buy this from us?” The answer is that we really don’t know. The market handles the transaction much like whenever we buy or sell a publicly traded stock. We don’t know who is on the other side of the trade.
Why would someone want to purchase the right to buy our stock at $52? The answer is that there are many reasons why someone would want to buy this. The short answer is the $200 investment gives the buyer leverage as if they actually owned 100 shares of XYZ. If XYZ goes up 5% the 100 shares of stock would be worth $500 more. The call option might then be worth $500 more also. This would amount to a huge 250% return for the call buyer on only a 5% move.
The risk is entirely with the call buyer. The call will expire worthless if the stock price stays below $52. Buying call options are risky. We’re only selling them.
You may be asking, what’s the catch? The answer is the potential of lost opportunity. We saw above that if the stock price jumps up to $60, we’d still have to sell it for $52. Remember, we still pocketed the $2 premium along with another $2 in capital gains netting out a positive $4. The fact of the matter is that we don’t know what the stock is going to do when we sell the call. Maybe it will go up to $60, and maybe it won’t. Even if you didn’t sell a call and the stock ran to $60, you’d only realize this $10 a share gain if you actually sold the stock. Prices go up and down all the time. You could easily loose the gain if the stock price heads back down. Continuing with this logic, this also assumes that you didn’t decide to sell the stock before it got to $60. The real world brings lots of different scenarios that you cannot foresee. Hindsight is 20/20. The bottom line in my view is “Did we make money?” If we are forced to sell at $52 and net a $4 profit, we no longer have exposure to the risk of owning the stock. We can then choose to keep the proceeds in money market, or do whatever we want at that time. This greatly limits our downside risk!
Covered calls provide a methodology to unemotionally take profits when you have them. The flip side is true also. It’s very easy to get emotional when your stock falls in value. Your account value is losing ground, you panic and sell. Now you’ve locked in losses. We want to do the opposite – lock in gains. Covered calls provide a downside strategy so you don’t have to panic and be so emotional.
Let’s think about what happens with XYZ drops down to $40. In this time period, you net out a -$8. Even with the covered call, you are maintaining most of the downside risk inherent every time you own a stock. Even so, by definition you are better off by selling the call. Assuming your cost basis is $50, your breakeven point is now down to $48. Once the call expires one month from now, you can sell another one. After that expires, sell yet another one. Etc. As long as you own a good company, one that you might even want to buy more of when it’s “on sale”, you don’t have to panic. Simply, keep selling covered calls and continue to lower your breakeven point until you are in the black.
Covered calls give you control that you wouldn’t have otherwise. In normal circumstances, the only thing you have control over is when you buy, and when you sell. You do not control what happens to the stock price after you buy. You can do all the right research. Spend time pouring over charts. Even utilize more exotic stock picking tools such as “stochastics” or Fibonacci numbers. And the stock can head lower right after you purchase it. Short of insider knowledge, this is just a fact of investing.
Covered calls are different. You can calculate your percentage return on the calls beforehand. The numbers are finite. You pick from the available calls listed your stock’s “option chain”. You’ll know the available expirations and be able to pick which one you want. You’ll decide which strike price to choose. You can see the current premium the market is paying, and set it using a limit order. Your returns on the covered call are not left up to chance. The stock price will still go up and down. But the strike, expiration, and the premium won’t change once you sell the call.
If that’s not enough…When you sell a call, the premium is immediately available in your account! You don’t have to wait until expiration to get paid. This too opens up a world of new possibilities. For example, if you have enough premiums, you could immediately buy more stock and sell even more calls speeding up your returns to create a compounding effect.
There is one last point to take note of. Not every stock has an option chain associated with it. Others have option chains that are thinly traded, in which case you may not want to mess with them. You can easily see what the option chain is for a particular stock by looking at either Google or Yahoo Finance.
I encourage you to spend some time going through the Learning Center links on www.inspirecapital.com. There’s a lot of great stuff there that will forever change your approach to investing.
Good luck. Invest Inspired!
For more information contact:
Michael P. McKee, CERTIFIED FINANCIAL PLANNER™