Investment newsletters will tell you that the covered call is a can’t-miss strategy, but are they right? Find out what this strategy is all about, here.
If you are a long-term buy and hold investor, there is an options strategy that you should know. It’s called the covered call strategy, and it involves a combination of stock and options. It’s a mildly bullish options strategy that is highly touted by newsletters as a way investors can earn extra income on the shares they own.
But is it safe and conservative as advertised?
The Mechanics of the Covered Call Strategy
A covered call is an options strategy that allows a trader to collect additional income on a stock they own. It’s considered a mildly bullish strategy because the upside of the trade is capped off, unlike a call option or long stock position which have “unlimited upside.”
Why would you do this?
Maybe you believe that the stock (or ETF) you are long has limited near-term upside. Instead of holding onto and waiting for the stock to move, you can passively collect income with a covered call.
Here’s an example of how it works:
A trader is long 100 shares of Facebook at $169.60. The total value of the position is worth is $16,960. The trader will be happy if the stock can return 15% over the next year or two, which would take shares to about $195 per share.
Let’s see what happens if they sell the $195 call that expires 466 days from now. The $195 calls are trading for about $15.25 of premium.
(Here are some of the option strikes for the June 19, 2020 options in Facebook. The calls are on the left, and the puts are on the right.)
Now, if the trader sells the $195 calls, they will collect about $15.25 in premium. The trader can place this trade as a single order from their trading platform or place it separately. The ratio of stock to calls should be 100 shares long for every call option short. In other words, if you had 1000 shares, you would sell ten call contracts.
Covered Call- What your trade is saying
Now, if you divide 1525 (the premium collected) by the value of the stock position (16,960), you’ll get 8.99%
How do you keep the full premium?
If the stock closes at or below $195 at the expiration date, however, that is not the maximum profit potential of the trade.
If the stock does go to $195, the trader will also gain $2540 from their long stock position.
In other words, the max profit potential on this trade is $4,065 or 24%
As you can see, the strategy has the potential to enhance your returns. Furthermore, it also acts as a partial hedge.
For example, by selling the $195 calls, you have more than $15 of downside protection. In this example, the trader will be hedged (169.60 – 15.25) to $154.35. In other words, selling the call option also gives them a cushion they wouldn’t have from being just long the stock.
Ways the strategy makes money
- Stock stays flat or declines modestly
- stock trades higher
As you can see, this strategy has more than one way to be a winner, which can be appealing to some traders who are used to trading equities and having only one way to win.
Now, what’s the downside of the strategy?
Well, your profit potential is capped off. For example, let’s say the stock trades to $300. The most the trader can make in the Facebook example is 24%. That’s because they are short the $195 calls. Furthermore, their long stock will offset the short call position.
When the trader sells a call option, they have an obligation to deliver 100 shares of stock to the buyer of the $195 call if the stock price expires at least one penny “in-the-money.”
Also, like a long stock position, your risk is not clearly defined. If Facebook were to drop by more than 15 points, the trader would no longer have any protection.
How Should You Trade the Covered Call?
The covered call strategy works well with blue-chip stocks. Most blue-chip stocks have relatively low volatility, and covered calls can help spice up returns by capturing the additional premium. Of course, when you look at the risk profile of a covered call, it’s the same as a naked short put.
One approach is selling long-dated calls, like the Facebook example, but there are other ways to make the trade. For example, instead of using long-dated options you can experiment with different strike prices and expiration periods. If the stock you are long is volatile than chances are you can collect some decent premium on selling near-term calls. If the short-term options expire, then you can roll-over to a different contract period and repeat the process.
Ideas for the technical trader
Let’s say you believe you’ve found good resistance levels on a chart; you can sell call options at that strike price. You can use this approach for short term swing trades. For example, here is an example of how Kyle Dennis uses support and resistance levels to sell calls.
The covered call is not the holy grail
As appealing as the strategy sounds it has its weaknesses. It is not the safest strategy but its also not the riskiest. It’s the same risk profile as a short put and only offers a partial hedge.
What are some safer strategies than the covered call?
If you are looking for a risk defined strategy that is mildly bullish, consider the bull call spread.
Another idea is to take part of the proceeds from the calls you sold and buy put protection with it, which reduces the profit potential but also provides a more magnificent hedge. The name of the strategy mentioned above is called a “collar.”
As with most options strategies, there is a give and take.
The Bottom Line
Some newsletters tout the covered call as a holy grail strategy, but it has its flaws. If you are a risk-averse trader, consider a bull call spread or collar. That said, the covered call strategy can help boost returns when compared to a stock only strategy.
Now, if you’d like to brush up on your options, make sure to get your copy of this free eBook: Option Profit Accelerator.