Selling a covered call can be a great tool for investors to generate some additional income off of shares they already own and to juice their total returns.
In many cases, the income generated from covered calls is many multiples of what the dividend income is, allowing you to not only keep your dividend incomes, but to significantly enhance it as well.
In this post, I will share exactly:
- what covered calls are
- When you should use them
- How you should use them
- What the potential outcomes are
- What the potential risks are
What is a Covered Call
A covered call is when an investor sells call options against shares of a company that they already own. As I mentioned above, the ultimate goal with covered calls is to generate some additional income from a stock that you already own. When used in the risk context, this is a great way to boost your income off of a stock by 2% – 3%.
The most common way to enter into a covered call, and the way that we will focus on, is to sell out-of-the-money (OTM) options above both the current market price (which makes them OTM) and above your ownership level. Entering into a covered call this way minimizes your overall risk to opportunity cost and the outright price risk of the stock moving lower than your ownership level.
When To Use Covered Calls
In my opinion, the best time to use covered calls is when you have owned a stock for a while, the expectation for forward growth is somewhat limited, prices are range bound, but you still want to hold onto the position.
Using myself as an example, I tend to be more of a long term investor, so it is not uncommon for me to hold positions for years. Holding positions for that period of time means that occasionally stocks that I own will become overvalued.
When stocks become overvalued you have traditionally had two options (no pun intended) – take some profit and invest elsewhere, or hold on and hope that the company can grow into that valuation. Logically, it’s easy to see that taking some profits would be the better solution in this example. There are instances, however, that even though a stock is overvalued, you may not want to sell. Those are a great opportunity to sell covered calls against your position and to reinvest that income back into other investments that remain undervalued.
For this example, let’s assume that you own 100 shares of Apple at $100/share. Currently, the stock price is trading at $119/share, and you don’t think that it will go above $125/share over the next three months.
Since your outlook for stock price appreciation is somewhat limited, you decide that it would be a good idea to sell a covered call against your position to help increase the total returns.
Looking at the options premiums for June expiration (roughly 3 months away), you notice that the $125 strike options are trading for a premium of $4.90. Since one options contract is the equivalent of 100 shares, that $4.90 represents $490, or a 4% return on the shares you already own.
You decide to sell one call option.
Note: it is incredibly important to remember not to sell a larger number of option equivalents than you have shares (i.e. don’t sell two option contracts if you only have 100 shares since each option contract is equivalent to 100 shares). Doing so would be selling a naked, or uncovered, call and is incredibly risky.
Since you already own the 100 shares of Apple, your risk selling the call option is limited and the various outcomes that you can experience are limited to the below.
The price of Apple remains below the strike price of the option you sold, or $125, but above the level that you own the stock at, or $119. The trade has worked out exactly as you had hoped.
You are able to keep the stock that you own, the share price did not fall below your ownership level, and you get to keep the $490 premium that you collected when you sold the option.
In outcome 2, let’s assume that the share price of Apple goes above $125/share. In this instance, there are two things that can happen.
- If the call goes above $125/share, it becomes In-The-Money (ITM) for the person who bought it from you giving them an incentive to exercise the option. If the option is exercised, you will be required to sell your 100 shares of Apple at $125/share. Although it is not ideal, your only real loss in this case is the opportunity cost of any additional appreciation above $125/share since you will no longer own the stock. If this happens, you will still get to keep the $25/share gain in the stock that you made from owning it and the $490 option premium.
- If the call goes about $125/share and expires above that price it will be automatically exercised by the exchange. If this happens you will be required to fulfill your obligation of selling 100 shares at the $125/share strike price. Again, this is not an ideal scenario, but your losses are minimized to the lost opportunity cost of additional gains on the outright.
In outcome 3, let’s assume that something terrible happens and Apple’s stock plummets to $90/share. This is the worst case scenario. In this instance you will be able to keep the $490 premium that you collected when you sold the option, but will lose $1,000 ($10/share x 100 shares) on the outright position.
Losing $1,000 on the outright could be terrible, or it could be an opportunity, it really just depends on your mindset. If you have no faith in the long term growth of the company, then losing the $1,000 likely puts you in a pretty tough spot where you will need to stomach some losses and move on. On the other hand, if you feel as though the long term prospects of the company are still good and the move down was just a short term market move, maybe this is a buying opportunity to add more shares. It’s all about perspective as the end of the day.
Another thing to think about with covered calls is dividends. Before you sell a covered call you will want to make sure you know when the next dividend payment is, if the company has one.
Below is an example of the Apple dividend payout from the nasdaq.com website.
The thing to know with dividends is when they pay and how much they are expected to pay. To get this information you first need to look at the Ex-Dividend date, or the deciding factor of whether a dividend is paid to owners or not. Said differently, if you buy a stock before the ex-dividend date you will receive a dividend payment for that quarter. If you buy a stock after the ex-dividend date you will not receive a dividend payment for that quarter.
The reason that this is important is because of “dividend risk.” Dividend risk generally only applies to in-the-money options and is the risk that the option gets exercised by the buyer to collect the dividend payment. Even with dividend risk, you will still fall under one of the three scenarios above.
Payoff & Risk Profile:
Below is the payoff and risk profile of the Apple example from above.
From this chart, it is easy to see that after the price of Apple’s stock goes above $125/share our gains on the option stop whereas our gains on the underlying stock continue to increase. Of course, we are using the underlying as collateral for the short call options to create a covered call position, so we are unable to realize any of those gains. This is where the opportunity cost of the lost gains comes into play.
Likewise, as the share price decreases both the option and the share price lose value at the same rate, but the return on the option is slightly above just holding the shares outright due to the premium that you collected.