The Covered Call Strategy

There is a simple and effective way to make money in the stock market that reduces current risk to share holders. Do this: buy shares and then sell off some of the rights in the form of writing a call option. The 'covered call' strategy is straight-forward and lucrative for anyone who trades shares.

The steps are easy:

1. Buy shares in lots of 1,000 (for Australia), or 100 (for USA)
2. Write and sell a call options contract for each share lot

Example: Stock XYZ sells for $5/share. In Australia you buy 1,000 shares. You sell a certain call options contract for $1/share.

This strategy works because it can compliment an existing strategy instead of replacing it much like renting a house can bring extra income while you are waiting to sell it on the open market. Another benefit is that you retain full rights to collect dividends of the shares you own.

Covered Call Writing: How it Works

What exactly are you writing and selling? Why is it called a 'covered call' strategy?

First, a 'call' is a type of contract that appreciates in value as the stock rises. A 'put' is an options contract that makes money when the stock price falls. Because you own the underlying shares of the contract, if the person who owns the call option wants to convert the paper agreement into actual shares, you are 'covered'. You already own the necessary equity to 'cover' the transaction.

What is the agreement that you are writing? Because you own the stock, you are allowed to write up an agreement with another party that outlines under what conditions you will sell the stock. This agreement is worth a varying amount of money based on certain conditions:

• Length of time until contract expires
• At what price he can purchase the shares (strike price)
• Volatility of shares

These are known as Options Greek, but deep knowledge of the inner workings of options is not really necessary at this level. Next, let us tackle a few different scenarios of selling options on real shares in the Australian stock market.

Covered Calls and Time

Time is money. If you own shares and sell call options on the shares for one year, these will generate more income than if you sold those same options with only one month worth of time.

Example: Australian stock CSL trades at $33.73/share. You buy 1,000 shares. You turn around and want to sell a certain call option for one month. This will generate $540 of total income. This identical call option with 3 years until expiration will generate over $6,000 of income for you.

Yes, more time on the contract equates to more money. Wouldn't everyone want to simply lock-in for a very long time then? A balance needs to be met. If you were able to safely generate $540 worth of income every month, then in 1 year you could make over $6,000 instead of waiting 3 years. However, trying to take small slices of profit every month is more risky. A volatile stock that moves rapidly up and down could severely limit the profit for the short-term options seller.

How far away should you write your call option? That depends on you. Consider some scenarios:

1. You own stock and are definitely going to hold it until next tax year. You only calculate capital gains once you sell the shares. Instead of just sitting on the shares and doing nothing, you write a short-term call option contract to generate a little more money. This works because you are determined to hang onto your share position regardless of whether share prices go up or down.
2. You own dividend paying shares and want to hang onto this stock for a very long time. By selling a long-term call options contract you can use the income to buy even more dividend-paying shares. In this example you may choose to write and sell a call option that spans many years.
3. You are holding stock and are worried about a short-term consolidation. Instead of selling the stock you choose to write and sell a short-term call options contract to offset a minor loss.

Some are worried that if you sell a long-term options contract, you are stuck in that position for the entire time. This is simply not true. All you need to do is re-purchase an identical options contract and you are free to do whatever you want with your shares. Of course, the call options contract devalues over time. The longer you wait until expiration the more profit you make.

Example: CSL trades at $33.73/share. You buy 1,000 shares and sell a certain call options contract with 3 years until expiration for $6,000. After 2 years you want to liquidate. You need to re-purchase the contract. The net difference between selling your shares and buying back the contract should be reduced to 2 or 3 thousand dollars in most cases. This means you made a few thousand dollars profit even though you exited the position early.

Options and Strike Prices

Another massive consideration is at what price you are willing to sell your shares at. You have to decide if you would like to sell your shares at some future date for less than current price, the same as the current price, or more than the current price. First instinct would be to question why we would want to sell for the current price or less, but the answer will come clear shortly.

• Selling at the current price is known as 'at-the-money'
• Selling below the current price is known as 'in-the-money'
• Selling above the current price is known as 'out-of-the-money'

All three strategies should make you money. Again, let us use stock XYZ. It is trading at $5 per share.

1. If you sell an 'at-the-money' contract, this means that the call option buyer is allowed to buy the stock at $5 per share at the future date. If the contract lasts one year, this may be worth $500 in income total (based on 1,000 share lots). You make no money if the stock rises, but are guaranteed the $500 in income. You also lose profit if the share price falls. For instance, if the share price fell to $4 per share you would keep the stock as the options holder has no rights to buy it at this level. The $500 of income does not fully offset your $1,000 loss.
2. You sell an 'out-of-the-money' options contract. The strike price is set at $6 per share. The call options contract holder cannot take your shares unless the stock raises $1 in value. This means that if the stock rises, you get the next $1,000 of capital share price appreciation! Sadly, this contract is not worth as much in upfront income since the price needs to rise for the agreement to take effect. You might only receive $250 in options income. Your total potential reward is higher if the stock rises, but you also have greater downside risk if the stock drops with a reduced amount of income to offset the losses.
3. You can sell 'in-the-money' options where the strike price, or the price you will sell at, is less than the current price. For instance, the options contract stipulated that the shares could be sold at $2.50. The contract would immediately be worth $2.50 in intrinsic or actual value to you, the shareholder. Furthermore, a small profit would be included. The options contract might be worth $2,600 -- which really only translates into $100 of net profit. The advantage is that the stock could fall all the way down to $2.50 per share and you would incur no loss at all.

As you can see, whether you sell the options contract with a strike price at, above, or below the current share price depends on whether you expect to make money from share price appreciation, income from the contract, or a blend of both.

Here are a few tips:

• Selling ‘at-the-money’ contracts provide the most 'net income'. If you expect the stock to hold its value with little up or downside movement, this is the best option possible for maximum income.
• Selling ‘out-of-the-money’ options are best when you anticipate share price appreciation. This way you profit directly from rising share prices while at the same time generate a little extra income from the sale of options.
• Writing ‘in-the-money’ options can be used in a couple of circumstances. If you want to heavily hedge your share position for a period of time without selling, merely sell deeply in-the-money options. This will generate little income but also protect your account. Secondly, when you are invested in dividend stocks, selling these options will greatly lower how much capital you need to pay per share. This effectively raises your dividend per dollar spent. Finally, if a stock is expecting a massive event such as FDA approval, you can lower risk by purchasing shares and selling deeply in the money options. This still might generate a large amount of income if anticipated volatility is high.

Questions on the Covered Call Strategy

When should I use the covered call strategy?
If you plan to hold a stock for at least one month, hopefully longer, then the covered call strategy can be a useful way to generate extra income.

How safe is this strategy?
It is probably the safest thing you can do in the stock market. The only real risk of losing money(as compared to the shareholder) is if you buy a stock, sell the options, and future expectation of the stock jumps dramatically. If you wanted to liquidate, you could incur a substantial net loss. This is one of the only instances where you could be worse off in the short-term than another trader who is only buying shares without the use of options.

What are the risks?
You have a risk of being assigned early if your options contract is American style. This really isn't a risk in the covered call scenario since it means you get your full profit immediately...without having to wait. This might not be desirable if you are using options to increase the amount of dividend shares you own. Because you can re-purchase the options contract at any time, the biggest risk is if the options value jumps between the time you sold it and the time you want to repurchase it (implied volatility is all that matters for net difference), or if the options are so ill-liquid that you have a difficult time buying them back.

What stocks are best for covered calls?
Usually, pick stocks that you would like to own. Dividend stocks are good, but you might also receive less options income then other comparable stocks. Growth stocks with big expectations also generate high options values. In general, the more volatile the stock you own, the more risk you acquire. By lowering the strike price of the options contract you can manage the risk.

A Covered Call Example (QBE)

The Australian stock QBE trades at $17.41 per share. We buy 1,000 shares and can now sell covered calls.

Here are some varying prices if we sold call options at-the-money with a strike price of $18

• One month until expiration: $210 income
• One year until expiration: $1,415 income
• Four years until expiration: $2,870 income

We decide that one year would suit our purposes for this stock. Next we need to decide on a strike price.

The column after the word ‘call’ is the strike price. The next column is the amount of income per share we receive. Over two years this stock has had a wide range of price from $27 to $17/share. The share price is quite low at the moment and could drop further. For this reason we are picking a strike price that allows for some appreciation over the year but still provides a healthy amount of income. We choose the $19 strike price calls to write and sell.

What is the effect? We have a potential gain of:

• $1.59/share in capital appreciation
• $1.04/share guaranteed income in writing options
• Lowered breakeven point to $16.37/share
• Dividend for the year equalling $1.28 per share
• Lower net cost means dividend yield is now 7.8% (1.28/16.37)

Our max profit is $3.91/share. Our total risk capital is only $16.37/share. This equates into 23.8% profit (before fees and commissions) as long as the share price rises 9.1% over the year. Of course, if share prices fell to $15.09 we would breakeven after including dividend and option income.

Covered Call Wrap-up

Writing covered calls can help an investor maximize his return. It will generate an income as he sells agreements on his stock, and lower his risk of a loss.