The Covered Call
Here is a way to generate steady income that significantly enhances your returns.
This article is written for educational purposes.
Let’s go over the concept of covered calls, touted as one of the easiest and safest option strategies, supposedly so safe, that the government allows it even in IRA accounts. I’ll say more about that at the end of this article.
In a previous article, I discussed selling (naked) put options, specifically naked puts, with the caveat that one should employ this tactic only on stocks one would not mind owning, and only write (sell) out-of-the-money strike prices.
To summarize some of the basic concepts, both calls and puts are contracts, each of which controls 100 shares of the underlying stock. Both puts and calls can be bought or sold.
You have four possible moves available: Calls can be bought or sold; Puts can be bought or sold. But within these possibilities are several permutations. In the former article, I discussed the concept of selling naked puts, that is, put options where we do not own the underlying stock.
We looked at some scenarios where the stock advanced in price, in which case your put would expire worthless, which is the ideal result. Here, you received a premium, and you don’t have to pay an additional commission to close the position, thus realizing the maximum benefit (although, as mentioned, nowadays commissions are quite reasonable). The other possibility was that the stock remained at the same price during the time of the put, which still meant that you would get to keep your entire premium. Or, the third possibility was that the underlying stock would decline in price. We used nVIDIA (NVDA) as our example when it was trading at $23.47, and we sold naked next month’s (March 2011) $20 strike price. For puts, when the market price of a stock is above the strike, the strike is said to be out of the money. Obviously, the converse is true: if the market price of the stock is below the strike price, it is said to be in the money. With NVDA trading at $23.47, the $20 strike is out of the money. You can see, therefore, that when writing (selling) naked puts, the stock can have a number of movements – go up in price, stay the same, or even go down in price – without significantly encroaching on our position. In our example, NVDA would have to go down by almost 15% before our strike price was violated, and put us at risk with our money.
In our example, the ROI (return on investment, your gain on the amount of money you put up as collateral) was 6.82% for a one-month return (the March 2011 $20 strike), or 26.98% if we moved our position to September 2011.
Among the above possibilities, we looked at what would happen if NVDA encountered some calamity, and indeed fell below our strike price. If NVDA fell below our strike price, one possibility is that it would be assigned to us. Remember that by selling the put, we sold someone the right to assign the stock to us. However, just because NVDA falls below our strike does not automatically force such assignment. There are other factors at work, which we will not cover here. Suffice it to say that should the stock be, in fact, assigned to you, you now have other possibilities to deal with it.
First, notice that in our example, we received $.48 per share for selling the $20 strike put. If NVDA is assigned to us, our cost basis would now be $19.52, a significant discount from its current market price. And that is presumably why we sold the put, because you wanted to own a stock at a discount to its current price. If the stock is assigned to you, you are now the proud owner of 1000 of NVDA at $20. Your choices now are (a) to sell the stock at the current price, because you are a revised opinion of the stock, and no longer wish to hold it; or (b) sell covered calls.
So what are covered calls? The word “covered” refers to covering an owned stock position. You own the underlying stock, and are seeking to cover it with premium in order to bring in more money.
Calls, like puts, are sold in contracts, with each contract controlling 100 shares. Let’s say that NVDA has been assigned to us, and we have decided to keep it, because our long-term opinion of the stock remains unchanged. We are willing to ride the small bump in the road, and while waiting for its price to recover, we will bring in more money by selling covered calls against our 1000 shares. We will assume for this example that the March 2011 expiration has passed, so we will look to the June 2011 expiration. This is a hypothetical example, because NVDA has not declined to the $20 range, so we really don’t know the precise price the calls are fetching right now. For the sake of example, let’s say the June 2011 $20 strike call is paying $3.00 (with NVDA currently sporting a price of $23.47, the June 2011 22.50 call is fetching $3.15). That represents a 15% premium. On your 1000 shares, you would be bringing in $3,000! Our cost basis was $19.52, less the $3.00 for the covered call, and now our cost basis is $16.52.
There is a problem with covered calls, however. If NVDA went down by 15% to trigger assignment, that may have been a one-time glitch, and the stock is destined to go right back up in price. If we cover our position with the $20 strike price, we are selling someone the right to buy the stock from us at $20. In other words, we are capping our return. So if NVDA rallies to, say, $26, we are stuck with having to sell it at $20. Of course, in such an event, we are free to buy back our calls and release our stock. Still, even if we chose to keep that position, we have agreed to sell it at $20 off our cost basis of $16.52. Our return of 17.4% would be generous, to say the least. Regardless of what happens to NVDA, we keep our premium for the covered call (unless we decide to buy it back to close). And in that event, you are releasing your funds, calculate your gains, and move on to the next stock – or get right back into NVDA if that is your pleasure.
At the beginning of this article, I intimated that I might disagree with the so-called safety feature of covered calls. The government allows them to be used in an IRA account because they do not require margin. If you own stock outright, you may write covered calls. You have no collateral, to speak of. But be aware that covered calls, though they do, in fact, enhance your return, do not protect the downside. In our example with NVDA, you are “protected” down to $16.52. But “protected” is not a correct word here. Your cost basis may be reduced, but this technique does NOT mitigate against further declines. The stock could go down to $0, and although covered calls do serve a great purpose in enhancing one’s returns, they do not prevent further losses. That is the province of puts – the other kind, the protective put.
Options are a wonderful tool for enhancing our stock positions. Why not learn to use them to your advantage?