Admire the Beauty of a Well-Timed Covered Call Program

One of the most versatile tools to use to generate income is through covered call writing, or the selling of covered calls on existing positions. In this volatile market, most of what you hear about options is from people buying puts and calls on very short-term directional trades.

Such trading of options is full of inherent risks because a person who buys an option contract is placing a bet for a set period of time that a particular stock or index will make a calculated move. If you think shares of IBM (IBM) will rise, but you don’t want to pony up the $155 per share to buy the stock, for example, you can buy an IBM $155 call option for, say, five months at a cost of around $750 per contract.

A call option gives the holder the right, but not the obligation, to buy 100 shares of the underlying stock at a specified price, called the strike price or exercise price, for the life of the option, which can be up to two years out.

In my example, one contract gives you the right to buy 100 shares of IBM for the next five months at $155 per share. If IBM is trading below $155 five months out, that call option is worthless. Get my point? If you own the stock and it declines, you still own the stock and have time on your side. But the time value of options is limited.

The flip side is to sell that inherent risk back to the market in the form of covered call writing. Selling covered calls is a conservative option strategy used by investors to realize additional returns on stocks while at the same time creating what is called portfolio insurance, a downside hedge that partially protects against price declines. A stock position is only hedged to the extent of the dividends paid in and premiums collected from selling calls.

Covered call writing involves selling a call option against a long stock position. The writer, or seller, of a call has the obligation, if exercised, to deliver 100 shares of the underlying stock at the exercise price until the expiration of the option. You are selling the right for someone else to buy your stock away from you at a given price for a given period of time.

By selling covered calls, an investor has the obligation, if exercised, to deliver 100 shares of the underlying stock at the exercise price until the expiration of the option. By assuming this obligation, the seller of covered calls collects a cash payment known as the “premium” for selling the rights to ownership of a stock at a given price for a given period of time.

Instead of buying that call option on IBM, we buy the stock and sell that same call option to a buyer who wants a leveraged long side trade on IBM. Assuming we pay that same $155 for 100 shares of IBM, we then sell one IBM $155 call for that same $750 in the example above. But this time, we keep the $750 and are willing to lose our 100 shares of IBM at $155 if the stock is trading above that level when the call expires. We break even on the stock, but make 7.5 points on the call option for a net gain of $750, or 4.8%, on our $15,500 invested.

Do that two to three times a year and you theoretically enhance your dividend yield of 3.3% on IBM shares by 10-15%. That’s assuming IBM behaves itself and doesn’t implode. Taking in 7 points is meaningless if a $155 stock crashes by 50%. The major risk in covered call writing is that the stock may decline more than the protection provided. This is where some sell discipline needs to be exercised, as with any stock.

Building portfolio gains through a proactive covered call strategy in a sideways market such as in the present can be very effective. Option premiums are high because of all the wide gyrations the market has experienced. Selling option premium into that volatility lets a seller of call options obtain heightened premiums.

The other risk that some people fear is that once you have written a call against an existing position, you have capped your upside and identified your return. Using our IBM example, say shares of IBM shoot up from $155 to $170 in a relatively short period of time. By selling the $155 calls for $7.50 per contract, we have limited our upside in IBM as the stock is certain to be called away at $155 and miss out on a 10% rally in the stock.

The ideal scenario for a successful covered call strategy is to sell calls against stocks that have enjoyed a recent run up and are likely to pull back on profit taking or simply consolidate its gains in a sideways pattern. Taking in premium after sharp upward moves in individual stock positions allows investors to get paid to time rallies and insulate gains.

A sharp fund manager employing a covered call (or “buy/write”) strategy will be deft at selling calls on a portfolio after a spike in values and then buy back those calls at a fraction of the price they were sold for or just let the calls expire worthless. If a stock looks like it’s going to make a big upward move, it might be prudent to close out a covered call position so as to not limit the profit opportunity. That’s a stock-by-stock, or case-by-case, decision.

To sum it up, when effectively utilized, the writing of covered calls is an important portfolio tool that has a strong place in the portfolios of many investors who seek additional income in a world of low single-digit yields. Currently, my Cash Machine newsletter subscribers own three funds within a model portfolio that employ a covered call strategy of some kind. It is one way to earn extra cash from investing in a stock.

In case you missed it, I encourage you to read my e-letter column from last week about how Baron Rothschild’s advice applies to oil stocks. I also invite you to comment in the space provided below my Eagle Daily Investor commentary.