There’s a strategy that many professional investors and Wall St. types use to increase their investment income. It’s open to you, too, as an individual investor. What are we talking about?
Writing covered calls.
This tends to be viewed on the conservative end of investment strategies but, as it involves the purchase of stock, it certainly isn’t without risk.
Here’s the lowdown on covered calls and how you can add this strategy to your own investment playbook:
What are covered calls?
First of all, it’s helpful to clearly understand the difference between “calls” and “puts”, as both are a form of exercising stock options:
Calls – A buyer of the call has a right to purchase 100 shares (one call is 100 shares) of your stock at a set price (the strike price) until the contract for the option expires. For example, I might own shares that I’ve purchased at $30 per share. I might sell a call option that says the buyer has the right to buy my shares if the price reaches $40 in the next six months.
Puts – The buyer of “put” options has the right to sell your stock at a set price until the contract expires.
A covered call means that you already own the stock that is being optioned, as opposed to a riskier investment path where you don’t already own the stock, known as a “naked call.” When you sell a covered call to an investor, this is also known as “writing a call.”
It’s also important to note that when you sell a covered call, you’re selling the right of the buyer to purchase your stock, however, they are not obligated to do so. There are plenty of reasons why someone might choose not to exercise their options before the contract period is up.
How to make money from covered calls
So, why would you sell covered calls on your stock in the first place? The short answer is because you will receive cash upfront for selling the option, or the “premium” paid per share by the buyer. It’s a way of deriving a more regular income from a share portfolio.
The buyer can choose to exercise their option or not until the contract period expires, but either way you as the seller get to keep the premium that has been paid. This is a way to create some guaranteed income from your stock and to get the cash sooner than you otherwise would. It may also go some way toward mitigating loss.
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Let’s look at an example. Say you bought shares and paid $50 per share. You sell a covered call for a $55 strike price within six months. This could play out in that period as either a win or less of a loss.
In one scenario, the market price of the shares goes to $55 or beyond, so the buyer chooses to exercise their option to buy. You still get the premium per share, plus the $5 per share profit at $55 sale price. If the stock blew past $55, say to $60, you still have to make the sale at $55 and the buyer is probably feeling fairly pleased with herself that she's bought $60 shares for $55. (This is the answer to any question about why someone might buy a covered call).
In an alternative scenario, the market price of your stock drops lower than what you paid for it, say to $45. The call buyer decides not to exercise her option to buy (you wouldn’t buy at $55 when you could pay $45). You get to keep the premium paid per share, but perhaps you choose to hold the stock in the hopes that it goes back up, or sell at a loss. In this situation, the covered call helps to cushion your loss somewhat, particularly if you compare to simply buying and holding the shares. At least this way you got the money from the premium.
Where does the price come from?
You’ll need to look up the options quote tables for the particular stock you are selling a call for. You’ll find a range of strike prices and the one you choose determines what the premium will be for your stock. The higher the strike price is over the current stock value, the less valuable the premium will be.
Let’s look at an example. Below is a screen grab showing the options chain for Apple stock on a given day:
If you look at the first line on the first table (AAPL1726E150-E), that last “150” is $150, the strike price. “Last” is the price that the most recent trade went through at ($3.70 per share), “Net” is how the last price changed since the closing price of the previous day, “bid” is the amount you will receive if selling the call and “ask” is what you would pay if you were buying it. The “volume” column tells you how many contracts have traded during the trading day and “Interest” tells you how many outstanding options contracts are still open.
What are the risks?
To begin with, look at the first scenario in the previous section, where the stock price went beyond the $55 strike price for the covered call. If you choose to sell a covered call you will always risk that the market price of your stock far exceeds what you’ve agreed to sell at, meaning that you miss potential capital gain. You’re not really “losing”, because you still make the premium plus the capital gain for what you’ve agreed to sell at, but you’re just not making what you could have on the stock.
Secondly, you face the usual risks of stock market decline after purchasing the stock that you option. While selling a call helps to cushion some of that loss because you keep the premium, this will only offset a portion of what you lose in a decline.
For some people who are quite comfortable with a buy and hold strategy on stock and will be happy to try and ride it out, selling a call will be like bonus money to them. For others who prefer to offload the stock, there is a caution to be aware of if you’re selling below the call amount. Technically, you should be buying the call option in order to close it, otherwise you can find yourself in the position of that “naked call” mentioned earlier, where you own an uncovered call position. This is something to check in with your broker about as not all will enforce this.
Another risk to consider is that you don’t get to sell your stock at a price you were aiming for. If we go back to our example of the shares bought at $50 with a call sold on them for $55, what if, over the lifetime of that call option, the stock climbed to $56, but then slumped to $49. The buyer of the call wouldn’t exercise their option (if they missed it at $55 to $56) and you would have missed that prime selling time at $56. Additionally, if they did call in the stock and it was immediately before it went ex-dividend, you would miss the dividend payment for the stock.
The bottom line…
Covered calls can be an excellent way to:
- Make some immediate income from your stock holdings.
- Make a little more on the sale of your stock by collecting a premium.
- Cushion the loss should your stock slide.
For these reasons, writing a covered call is seen as a lower risk proposition than simply “buy and hold” for stock, however it is not without risk. You will still wear the usual risks of the stock market by purchasing shares, especially in the event that they decline.
Like any investment, you should go in having done your homework on the relative risks and rewards.