The 6-Week Options Trading Kickstarter: Covered Calls

By Steve Smith  AUG 07, 2012 12:00 PM

Steve Smith breaks down a popular options strategy.

 


MINYANVILLE ORIGINAL

Editor's note: To help investors get their feet wet with options trading, Minyanville has launched this "6-Week Options Kickstarter," an educational series aimed at increasing understanding of the basic nuts and bolts of options. In this series, veteran options trader Steve Smith will take you through options fundamentals with an emphasis on real-world applications. Note: Intermediate or advanced-level traders may get more mileage out of Minyanville's 9 Weeks to Better Options Trading series.

Covered calls are among the most popular options strategies pushed by sell-side brokers and employed by traders.

But the reasoning behind both sides’ attraction also exposes some myths that retail investors should be aware of before embracing this approach. Let’s take a look at the pros and cons.

A covered call is created by being long a stock, and short call options on that same stock.

Typically, one call is sold for every 100 shares of stock.

If the positions are created simultaneously it is often referred to as a “buy/write.”

The premium received from the sale of the calls reduces the effective cost basis of the stock, providing some downside protection, and a potential boost – or reduction -- in returns depending upon the price action.

Let’s look at an example.

On Monday, with IBM (IBM) trading at $200 per share, one could sell the September $205 calls for $1.80 per contract.

As with all options positions, there is a tradeoff between the benefits and costs. While the downside is cushioned a bit, the potential upside is capped as the stock will be “called away” if it is above $205 at expiration. In other words, if the stock is above $205 at expiration, the buyer of the call option will exercise his or her right to take ownership of the stock at a cost of $205 per share.

In this case, the effective sale price would be $206.80, which is calculated by adding the strike price ($205) and the premium collected ($1.80).

A trader can adjust the risk/reward by adjusting the strike price and expiration date of the call sold. Selling options that are close to being in-the-money can bring in more premium up-front, but there is a higher probability of having the shares called away, limiting upside.
Another tradeoff comes in the form of volatility. A covered-call strategy works best, and will outperform a plain long-stock position, when shares are stable, or trending only moderately higher. 

That’s an apt description of low-volatility stocks, where premiums collected will comparatively low.  For example, with AT&T (T) trading at $38, the September $40 calls, which have an implied volatility (or IV) of 16%, can be sold for $0.18, giving a return of less than one-half of 1% if the stock stood still.   

For comparison, let’s take a look at Sourcefire (FIRE), which is trading at $46 per share. The September $50 call, which has an IV of 55%, can be sold for $2.45, providing a 5% return if the stock stood still. And note that the Sourcefire calls are 8% out-of-the money (or OTM) while the AT&T calls are only 5% OTM. This means that Sourcefire also has more room for upside gain. 

But let’s also note that AT&T has a 4.7% annual dividend yield, which helps close the performance gap. In this low interest rate environment, writing calls against dividend-yielding stocks can be a decent way to boost income. 

Repeatable Offense?

Brokers love to promote covered calls as a relatively conservative strategy, and investors who claim they would never sell naked options (meaning being short an option with no offsetting stock position) are all too willing to buy into that notion. But the reality is that the risk/reward of a covered call is no different than selling a comparable put short. 

Let’s go back to IBM. The September at-the-money (or ATM) $200 call can be sold for $4. This would give you a downside breakeven point of $196, which is calculated as the stock purchase price minus the premium sold ($200 - $4= $196) and would have a maximum profit of $4 for an effective sale price of $204. That is the strike price plus the premium sold ($200 + $4 =204).

By comparison, the $200 put can be sold for $4.90, which means your effective purchase price if you were assigned the stock would be $195.10, which is the strike price minus the premium collected ($200 - $4.90 = $195.10) while the maximum profit is $4.90, which is the amount of premium collected. 

However, when we account for dividends, the risk/reward of a covered call and naked short put is exactly the same. Adding the $0.90 to the $4 equals $4.90 -- the same amount.

In IBM's case, a $0.90 dividend payment is scheduled for the holding period prior to expiration. Investors long IBM stock would collect that $0.90 dividend, extending the profit on the covered call transaction to $4.90 -- exactly the same as the $4.90 profit on the short put.

Another misleading notion is the concept of calculating annual returns based on selling calls on a 30- or 60-day cycle. Let’s assume that with IBM, one can garner a 3% return on an ATM option with 60 days until expiration. One should not assume this a repeatable event six times per year under the assumption that you’ll earn 18%, or 19.7% with dividend, over the next 12 months. It is highly unlikely that the stock will remain flat for a year.  The stock will either be called away or you’ll have to adjust the strikes up or down mid- expiration, which will cut into returns.  

Since the possibility of assignment is central to this strategy, covered calls make more sense for investors who view assignment as a positive outcome. Because covered-call writers can select their own exit price, assignment can be seen as success; after all, the target price was realized and should only utilized by those willing to part with the shares.

Here is a complete schedule for the 6-Week Options Trading Kickstarter. I recommend starting at the beginning if you're new to options:
 
1. What Are Options, and Why Should We Care About Them?
2. Option Pricing Basics
3. Meet the Greeks
4. How to use Options: Three Basic Principles
5. Covered Calls
6. Hedging, Portfolio Protection, and Avoiding Disaster

Twitter: @steve13smith

No positions in stocks mentioned.

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