The Covered Call: An Income-Generating Options Strategy
The covered call provides extra income to a buy-and-hold strategy. In exchange for this income, there is a risk of lost opportunity. If the stock’s price rises well above the fixed strike price of the call, you have your 100 shares of stock called away below current market value. For some investors, this is an unacceptable risk; for others, it is gladly accepted given the potential extra returns from writing covered calls.
A Few Options Basics
The popularity of options trading has grown in recent years. Many investors and traders have realized that options can be used not only to speculate, but also as a means for managing a long-term stock portfolio, taking profits without needing to sell stock, and reducing the threat of losses. Among the dozens of possible strategies, covered call writing is especially popular for its potential to generate extra income for a portfolio.
Options are intangible contracts that provide rights to their owners. A call option provides the right to buy shares. (The second type of option, the put, gives you the right to sell.) The stock involved in every call trade is the underlying security. Call options have two other specifications: the expiration date (the date on which an option expires and becomes worthless) and the strike price (the price per share at which 100 shares of an option can be bought or sold when exercised). None of these terms can be changed.
A buyer, or owner, of an option has the right to exercise the contract. In the case of a call, this means that the right involves “calling away,” or purchasing, 100 shares of the stock at the strike price. For example, if you own a 70 call and the underlying stock moves to $85 per share, that call gives you the right to buy 100 shares at $70, or $15 per share below current market value.
Call buyers take considerable risk. About 75% of all calls expire worthless, so buying is a speculative strategy. Some traders use options to time entry and exit points to take advantage of short-term price changes, but as expiration nears, the option loses value.
This happens because part of the option’s premium (the current value of the option), its time value, falls, ending up at zero on expiration day. The rate of decline accelerates as expiration approaches, making buying options a difficult way to profit consistently. (The time to expiration impacts value because the longer the period to expiration, the greater the probability that the stock will reach and move beyond the exercise price. As the expiration date nears, time value decreases because there are fewer days during which the contract can be exercised before it expires.) Time value is a big problem for call buyers.
Selling options is a more profitable approach, for two reasons. First, when you sell an option, you receive the premium instead of paying it. Second, the decline in time value is an advantage to you as a seller. As time value declines, a short call can be closed, creating a profit. This profit is the difference between the original sale price (the option’s premium) and the lower closing purchase price. (When you write, meaning sell, an option contract, you are short the contract. The term “short call” refers to the fact that you want the call contract to decrease in value, to $0, after you have sold it.)
Selling Call Options
You can write a call that is “covered,” meaning you own the underlying shares, or “uncovered,” where you do not already hold the shares.
The Risky Uncovered Call
Selling an uncovered, or “naked,” call is one of the riskiest option strategies because a stock’s price can rise as high as the market moves it. One huge problem with selling calls when you do not own 100 shares of the underlying security is the high risk involved.
For example, if you sell an uncovered 70 call (strike price is $70 per share) and you get a premium of 4 ($400), as long as the stock price remains at or below $70, all of the premium is going to be profit. But what if the stock’s value rises to $95 before the option expiration date? In that case, you would have a net loss of $2,100 because you would need to buy the stock at the prevailing price of $95 in order to deliver it at the previously contracted price of $70. Table 1 shows the math.
|Price for 100 shares @ $95 per share||$9,500|
|Less: exercise price of 100 shares with a 70 strike||–$7,000|
|Loss on the stock||$2,500|
|Less: premium received for selling the call||–$400|
|Net loss on the uncovered call||$2,100|
The risk of selling an uncovered call is unacceptable for most traders, even though 75% of all calls expire worthless. If the stock price rises, the market risk is simply too great.
The Covered Call Alternative
Just as the uncovered call is a high-risk strategy, the covered call is on the other side of the risk spectrum, relatively speaking. It is one of the most conservative options strategies.
The primary argument against the covered call is that if the stock price rises above the strike price, profits on the stock are limited to the price specified in the contract. In other words, no matter how high the stock trades, you can only sell the stock at the price specified in the contract, which is the “strike price.”
Examples of Covered Calls
The first rule for covered call writing: Pick the company as a first step, based on your investment standards and risk tolerance. This is a huge subject area beyond the scope of covered calls; but it is invariably a mistake to use covered call writing as a primary method for picking stocks.
Assume that you have two stocks you are considering for your portfolio. In both cases, you are happy to hold these stocks for the long term but, given the right premium levels for covered calls, you are also happy to risk having shares called away.
Two stocks are used in the following examples: IBM IBM and Caterpillar CAT. A position of 100 shares in IBM purchased at $120 per share and a position of 100 shares in CAT purchased at $58 per share is assumed. Based on the stock and option values at the close of June 30, 2010, IBM closed at $123.48 and yielded a dividend of 2.1%. Caterpillar closed at $60.07 and yielded a dividend of 2.9%.
The IBM calls available as of the June 30 close are based on a limited range of strikes between 125 and 135 expiring in the three closest expiration months. The CAT calls are based on strikes between 60 and 65 expiring in the three closest expiration months. These months are always the two closest months and the next following month in a stock’s expiration cycle. IBM’s cycle is JAJO (January, April, July, October), while CAT’s cycle is FMAN (February, May, August, November). Calls for both stocks are summarized in Table 2.
The next step is to pick the “best” strike. All of these are above the purchase price for each of the stocks. However, the premium levels are quite different. The longer the time to expiration, the higher the dollar value of the call for the contract closest to the stock’s current price—but the lower the annualized yield.
To annualize, calculate the yield by dividing the option premium by the current stock price. Then, divide the yield by the holding period (in months) and multiply by 12 (months). This creates the yield earned if the position were kept open exactly one full year. Note that because the date of these options is June 30, the time to the July expiration is 23 days, which makes the holding period about 75% of one month. Table 3 shows the math for calculating the annualized yield based on comparisons between the option premium and current value of the stock for each of the options.
|IBM Options, Annualized Yield|
|July (0.75 month):|
|125:||(2.03 ÷ 123.48 ) ÷ 0.75 x 12||=||26.3%|
|130:||(0.52 ÷ 123.48 ) ÷ 0.75 x 12||=||6.7%|
|135:||(0.11 ÷ 123.48 ) ÷ 0.75 x 12||=||1.4%|
|August (1.75 months):|
|125:||(4.31 ÷ 123.48 ) ÷ 1.75 x 12||=||23.9%|
|130:||(2.31 ÷ 123.48 ) ÷ 1.75 x 12||=||12.8%|
|135:||(1.01 ÷ 123.48 ) ÷ 1.75 x 12||=||5.6%|
|October (3.75 months):|
|125:||(6.35 ÷ 123.48 ) ÷ 3.75 x 12||=||16.5%|
|130:||(4.25 ÷ 123.48 ) ÷ 3.75 x 12||=||11.0%|
|135:||(2.56 ÷ 123.48 ) ÷ 3.75 x 12||=||6.6%|
|CAT Options, Annualized Yield|
|July (0.75 month):|
|60:||(2.32 ÷ 60.07 ) ÷ 0.75 x 12||=||61.8%|
|62.50:||(1.23 ÷ 60.07 ) ÷ 0.75 x 12||=||32.8%|
|65:||(0.54 ÷ 60.07 ) ÷ 0.75 x 12||=||14.4%|
|August (1.75 months):|
|60:||(4.00 ÷ 60.07 ) ÷ 1.75 x 12||=||45.7%|
|62.50:||(2.85 ÷ 60.07 ) ÷ 1.75 x 12||=||32.5%|
|65:||(1.90 ÷ 60.07 ) ÷ 1.75 x 12||=||21.7%|
|November (4.75 months):|
|60:||(6.30 ÷ 60.07 ) ÷ 4.75 x 12||=||26.5%|
|62.50:||(5.50 ÷ 60.07 ) ÷ 4.75 x 12||=||23.1%|
|65:||(4.05 ÷ 60.07 ) ÷ 4.75 x 12||=||17.0%|
Annualized returns should not be used as a yardstick to judge the value of all covered call writing. For example, a CAT July 60 call shows annualized yield of 61.8%, which is quite impressive. However, this does not mean that writing a series of similar calls is going to produce that rate of return over the coming year. Movement in the stock, changes in markets, and the timing between entry date and expiration make actual returns less certain. However, annualized yield in options analysis is valuable for making accurate comparisons between companies.
In the example above, the yields on Caterpillar are vastly higher than the yields on IBM. This means CAT is a more volatile stock, and thus includes higher market risks than IBM. So the decision to use one company or the other for writing covered calls is a matter of matching the market risk of the stock to the risk tolerance of the individual investor.
A second comparison can be made on dividend yield. Based on the June 30 prices, IBM yielded 2.1% whereas CAT yielded 2.9%. This difference in dividend should also affect the decision to use one stock over the other. The rationale is that the higher yield will produce more relative income.
Assuming you would have picked Caterpillar as a purchase choice, the next step is to compare available options. Table 3 shows that shorter-term options yield better returns than longer-term options. The CAT 60 July call offers comparatively more upside. It yields over 60% annualized while generating immediate income of $232 (the premium payment). Exposure time is about 23 days. If the stock price closes below $60 per share, this call would expire worthless. If exercised, the call writer keeps the $232 plus dividends, plus a capital gain of $200 ($60.00 – $58.00).
These examples use calls that are above the purchase price of the stock. Writing covered calls on a stock whose price has declined below your original purchase price is not recommended. The profit from selling calls with strikes above the price you originally paid for the stock will not be large enough to offset your loss in the stock itself. In this situation, you need to wait out the market until the value of the stock rises above your original cost basis.
Evaluations and Comparisons
Comparing premium income on an annualized basis as well as dividend yield creates valid comparisons in picking a covered call. Here are some additional things to consider when deciding whether or not covered call writing is an appropriate strategy for you:
- What are the transaction costs for trading? Calls are quite cheap when compared to stocks; and the trading costs involved are quite low. A round-trip (buy and sell) for a call should be less than $20 if you use an online discount broker.
- How about tax consequences? Income from a covered call is always treated as a short-term capital gain or rolled into the capital gain on exercised stock. A more serious tax consequence is the possibility of losing the benefit of long-term gains treatment. If you sell a call that is lower than one increment from latest closing price in most cases (meaning the strike is well below the stock’s current market value), you could be required to treat the gain as a short-term profit. IRS Publication 550 discusses tax issues involving options.
- Does it make more sense to just sell the stock? Not every investor holding 100 shares of stock should write covered calls. In some cases, you are better off selling shares and taking profits. If the criteria for holding a company’s stock have changed, it makes sense to sell right away and replace it with shares of a company that do meet your criteria. It may also make sense to take profits when you have a substantial net loss in another transaction, so that losses and profits are offset in the same tax year. And it makes sense to sell when a sector is cyclically moving out of favor or when another company in the same sector has greater growth potential. Covered calls should be written only on shares of companies you would prefer to keep in your portfolio.
Common Options Terms
Call: An option granting its owner the right, but not the obligation, to buy 100 shares of a specified stock, by or before a specific date, and at a specific fixed price.
Covered call: A strategy of selling one call per 100 shares owned of the underlying security. If exercised, the market risk is eliminated because shares are available to be called away. Covered call writers receive the premium and earn dividends as long as they own the stock.
Exercise: Using an option to trade in the underlying security. This entitles the call owner to buy (or, “call away”) 100 shares of stock.
Expiration cycle: The months in which options are going to expire. There are three annual cycles: JAJO (January, April, July, October); FMAN (February, May, August, November); and MJSD (March, June, September, December).
Expiration date: The date on which an option expires and becomes worthless.
Premium: The current value of an option; the amount a buyer has to pay to acquire an option, or the amount a seller receives.
Strike price: The price per share at which 100 shares of stock can be bought or sold when an option is exercised.
Time value: The portion of an option premium based on time to expiration; as expiration approaches, time value declines at an accelerated pace.
Uncovered call: An option contract sold by an investor who does not own 100 shares of the underlying security.
Underlying security: The stock or other security the option contract is written on, which cannot be exchanged or replaced.
A covered call is going to end up in one of four ways:
- The call option expires worthless. This means that the premium you received is 100% profit. As soon as a call you wrote (aka “a short call”) expires, you can immediately write another call and generate even more short-term income.
- You close the position at a profit or to limit a loss. You are free to close a call option you wrote (aka “a short call”) any time before expiration. If the call’s premium drops substantially, it might make sense to execute a closing purchase transaction by buying a call with the same strike price and expiration as the one you wrote, take the profit, and then write later-expiring calls. If the stock price has risen, you can also close a short call to limit losses. This is a logical choice when the loss on the short call is lower than the appreciation in the underlying stock.
- The short call is exercised. This can happen at any time, but is most common on the last trading day of the expiration month. In the case of exercise, your 100 shares are called away and your net profits include capital gains, the option premium and dividends.
- The short call is rolled forward. You can avoid or delay exercising with a forward roll, a transaction in which you close one call and replace it with another that expires later. A word of caution: The forward roll can unintentionally turn a qualified covered call into an unqualified covered call. A qualified covered call does not change the tax status of the underlying stock, whereas an unqualified covered call can. If you are close to reaching long-term capital gains status on your shares of stock, but your roll creates a new position with a strike more than an increment below current market value, the period counting toward favorable long-term treatment stops. In other words, if the stock is called, you could end up paying taxes on short-term gains regardless of how long you have held the stock. Consult a tax professional about how a covered call strategy will impact your tax situation.
Here are five guidelines for writing covered calls:
- Select the stock as a first step. Never buy stock only to write covered calls; apply a sensible standard for picking companies whose stock you want to own.
- Be willing to accept exercise. When you sell a covered call, you are granting the right to someone else to call away your stock. You need to be happy selling 100 shares at the strike price.
- Pick a strike higher than the price you paid for the stock. If a covered call is exercised, it should yield a capital gain and not a capital loss. For example, if you buy shares at $69, look at calls with strikes of 70 or above. Avoid writing covered calls with strikes below your cost. Your broker will have a table showing contracts for various months.
- Include dividends in the comparison. When comparing the income from covered calls, remember that dividends represent part of the overall return. So for two or more stocks you might buy, if the fundamentals are approximately equal, opt for the higher-yielding company.
- Make sure you can accept lost opportunity risk. Exercise means you lose the potential for higher capital gains in the stock. So, you must be willing to lose the occasional big profit in a stock in exchange for the income from covered call writing.
Evaluate covered call writing like any other option strategy: Be aware of the risks. For covered calls, you live with the lost opportunity risk or the sacrifice of potential profits you could earn by just owning stock when the price rises dramatically. The covered call fixes your sales price at the strike in exchange for the call premium you receive.
Other important risks are knowledge risk (the risk of entering transactions when you do not fully understand what is involved); capital risk (the need to keep money tied up in the long stock to cover the short option); and the potential risk of having stock called away that you want to keep.
With these risks in mind, if you want to write covered calls, you need to make sure you are willing to accept the premium in exchange for the potential of losing a large capital gain. You also need to make sure you understand the transaction. Finally, you need to know in advance that having stock called away at the strike is an acceptable outcome.