Wednesday, 8th September 2010

Writing Covered Calls

Written by George Traganidas Topics: Articles, Options, Wealth Building
By Jeff Fischer
August 10, 2009

Why use covered calls?

  • Income: To generate cash on a stable stock.
  • Defense: To profit if a stock you own slips in price.
  • A better sell price: To obtain a higher price when you’re ready to sell.

Foolish facts to know:

  • The command to start a covered call on your brokerage site is “sell to open,” “sell” or “write.”
  • You write one call option contract for every 100 shares of the stock you own.
  • When you write a call option, it shows up in your account as a cash credit.

Welcome to class, Fools! Today we’re going to introduce you to a popular option strategy involving calls. A call appreciates in value as the underlying stock price goes up, so you buy a call if you’re bullish on a stock. But more often, we’ll sell — also referred to as “write” — calls, profiting if the underlying stock holds steady or goes down, and selling the stock for a higher profit if it increases enough.

What Is a Covered Call?

A call is “covered” when you already own shares of the underlying stock. You write covered calls when you’re willing and ready to sell your stock at a higher price. The calls pay you extra money above that sell price. The catch: You must own at least 100 shares of a stock in order to write covered calls on it, and you must forego any potential profits above your option’s strike price (your desired sell price).

For example, suppose you bought a $10 stock that’s now climbed to $18, and you’d be happy to sell at $20. You can write (“sell to open”) $20 strike price covered calls that pay you $1 per share in option premiums and expire in two months. If the stock is below $20 by then, the call options simply expire, you keep the $1 per-share premium, and you may write new covered calls for more income. If the stock is above $20, your stock is “called away” (sold from your account), and you’re paid $20 per share. Including the option premium you were paid, that equates to a sell price of $21. However, even if the stock were to jump to $25, you’d still need to sell your shares at $20 to honor the calls. That’s the potential loss of upside.

Before we get into more details, listen up, Fool: Tread carefully. When you sell a call option, you must be ready to sell — that is, deliver to the option buyer — the underlying stock if it increases to the option’s strike price. If you already own the stock and thus have this part, er, covered, this options strategy is low-risk and appealing for newbies and old pros alike.

How Do We Use Covered Calls?

There are three main reasons to write covered calls. Let’s start with the most basic.

1. Income

The purest strategy is to buy stock specifically to write covered calls on it. This can provide steady option payments (with the potential for capital gains and dividends) and downside protection. We suggest this strategy on large, stable businesses trading at reasonable prices.

We recommend writing calls at strike prices modestly above the stock’s current price (your initial buy price). This provides room for appreciation before you’d sell via the calls. It also gives you a larger option payment and thus more downside protection.

For example, let’s say you’ve found a stable business selling at $15 per share and paying a 3% dividend. Although you believe there’s little downside risk, you don’t think shares will soar (if you did, you’d simply buy the stock outright).

  • Assume you buy 300 shares (remember, you must buy 100 shares for each call) at $15 each and immediately write three covered call contracts with a $17 strike price (that’s where you’d sell the underlying stock). The calls pay you $1 per share and expire in three months. This nets you a potential sell price of $18.
  • If the shares increase above $17 and are sold away in three months at a net $18, you’ve made 20% ($3 per share, or a total of $900 on your $4,500 purchase).
  • If the stock is below $17 by the option’s expiration, you simply keep the $1 per share, so you’ve made 6.6% on your investment so far. Treat that $1 as a form of yield. It also means you have 6.6% downside protection on your shares, and your effective new break-even price is actually $14. You can continue to write new calls for income.

Using a covered call strategy for income, your worst-case scenario is a dramatic fall in the stock’s price. It’s challenging to recover from a large decline with covered calls alone. So it’s important to select stable businesses at inexpensive prices. If you do, your downside will be limited, and the odds are high you’ll make money over time.

2. Defense

If you own a stock that you believe will be stagnant or decline modestly over the coming months, but you don’t want to sell your shares yet, you can write covered calls as a hedge — and get paid while you wait for your investment thesis to unfold.

We don’t advise using this defensive covered call strategy on stocks with strong fundamentals and near-term catalysts. You don’t want to miss large gains. So consider this strategy only in these scenarios:

  • There is little downside risk in the stock price.
  • There is little upside potential in the near term.
  • You want to get paid via covered call writing while you wait for the stock to appreciate, but if it appreciates more quickly than you expected, you won’t be upset about selling.

Writing covered calls in a flat or down market is a defensive strategy to help you generate returns even during stagnant periods. You just need to be careful that your stocks aren’t sold away too cheaply.

3. A Better Sell Price

Finally, when a stable stock that you own is trading near its fair value estimate and you’re ready to sell, writing covered calls at your desired sell price can increase your total sales price. The calls essentially pay you extra cash to sell your stock at the price you want to sell at anyway. However, there are caveats. First, make absolutely certain you want to sell at the price you’ve chosen. Second, if the stock is volatile and you think it’s currently overpriced, you should just sell it — forgo the option income. You don’t want to risk the stock falling several dollars before you sell just for a few extra bucks in option income. Finally, the stock could exceed your desired sell price but fall back down before your call options get exercised, making you miss your sell price. Options are usually exercised only at expiration, and in the meantime, good sell prices may come and go.

Covered Calls At a Glance

Strategy Good Candidates Goal
Writing covered calls for income A stable, healthy business with a reasonably priced stock that preferably also pays a dividend, bought specifically to write covered calls. Aim for at least 7% to 8% returns (if the option is exercised) within six months for a 15% annualized gain; aim for downside protection of at least 5%.
Writing covered calls for defense A stock you already own that currently lacks a catalyst and is stagnant or unlikely to rise in the near term. Covered calls make a sleepy position profitable while awaiting a catalyst; they can also provide downside protection or hedging.
Writing covered calls for better sell prices A stable stock near fair value that you are willing and ready to sell from your portfolio. Add extra income to your sell by writing a covered call at or near your desired exit price.
Writing naked calls (not recommended by us!) A market index, when volatility is low, as a hedge. Writing naked calls on individual stocks is not advised because the risks far outweigh the rewards. Hedge the S&P 500 or any index you like by writing call options that will earn you returns unless the indexes rise 5% or more in a few months (not advised in volatile markets).
When not to write covered calls Avoid writing covered calls on leading businesses with strong catalysts and on stocks sporting high rates of growth with upside surprises possible. You don’t want to limit your returns on strong stocks, many of which can carry premium prices for years.

When Not to Use Covered Calls

When you do not own the underlying shares, writing calls is dangerous. Referred to as a “naked call,” this strategy is about as risky (or risqué!) as it sounds. If the stock soars, you’ll be forced to buy shares at the inflated price and deliver them to the call owner (you were the call seller, remember) at the lower strike price. As with a naked short sale, your losses are potentially unlimited.

It’s also best to avoid writing covered calls on reasonably valued, strong businesses that you want to own for the long term — or on your best performers, including high-growth stocks. Additionally, avoid the temptation to write calls for income on your stocks that have fallen sharply. In most cases, the calls won’t pay you well, and they’ll lock you into a lower potential sell price than you’d normally want.

Closing Early and Rolling Forward

When you write a covered call, you may choose to close it early (“buy to close”) if you’ve changed your mind or want to keep owning the stock. You’ll pay the going market price for the option, either more or less than you wrote it for originally, booking a loss or a gain on the option itself (we avoid closing early at a loss, instead sticking to the original trade). Once you’ve earned 85% or more of your potential gain on a call (say you wrote a covered call for $1 and it’s now asking only $0.15), you may want to close it early in order to write a new call that will pay you much more. Finally, in some cases you may want to simply roll a call forward to a future month, closing your existing call to write the new one. This can buy you more time for your strategy, and higher total option premiums.

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