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By Kim
Covered calls are popular among investors looking for a conservative way to generate additional income from their stock holdings. However, it's essential to understand both the benefits and risks before implementing this strategy.
Example of a Covered Call:
Long Position: You own 100 shares of XYZ stock, currently trading at $50 per share.
Sell Call Option: You sell a call option with a strike price of $55 for a premium of $2 per share.
Outcomes:
Stock Price Below $55: The call option expires worthless, you keep the premium, and you still own the shares.
Stock Price Above $55: The call option is exercised, you sell your shares at $55, keep the premium, and realize a profit from the stock's appreciation plus the premium received.
Understanding Greeks and Covered Calls
If this is your first parlay into covered calls, you also need to familiarize yourself with options Greeks.
Options Greeks are key metrics used to understand the behavior of options prices. They measure various risks and sensitivities in an options position. When using covered calls, understanding the Greeks can help investors make informed investing decisions.
Delta
Delta measures the sensitivity of an option's price to a $1 change in the underlying asset's price.
For a covered call, the delta of the call option is positive but less than 1. This means if the stock price increases by $1, the call option’s price will increase by an amount less than $1. As a result, the covered call position (long stock and short call) will experience a partial offset of gains in the stock by the losses in the short call.
Gamma
Gamma measures the rate of change of delta with respect to changes in the underlying asset’s price.
Gamma is the highest for at-the-money options. For covered calls, a lower gamma (typical of deep in-the-money or out-of-the-money calls) indicates less sensitivity to price changes in the underlying stock. This means the delta of the option will not change as dramatically with price movements.
Theta
Theta measures the sensitivity of the option’s price to the passage of time (time decay).
Theta is particularly important for covered call writers because it represents the premium decay over time. As the option approaches expiration, its value decreases, benefiting the seller. For covered calls, a higher theta means the option loses value faster, which is advantageous to the call writer.
Vega
Vega measures the sensitivity of the option’s price to changes in the volatility of the underlying asset.
Vega is important because it indicates how much the option price will change with a 1% change in implied volatility. For covered call writers, a decrease in volatility after selling the call is beneficial as it reduces the option’s price, making it more likely to expire worthless.
Practical Application in Covered Calls
1. Selecting Strike Prices: Understanding delta can help in choosing the right strike price. Higher delta options (in-the-money) have a higher chance of being exercised, while lower delta options (out-of-the-money) have a lower premium but less likelihood of being exercised.
2. Timing and Expiration: Theta helps investors decide the optimal expiration date. Shorter-term options decay faster, benefiting the call writer due to higher time decay.
3. Market Volatility: By monitoring vega, investors can choose to write covered calls when volatility is high to capture higher premiums while being aware of the risks associated with potential volatility decreases.
Example Scenario:
Stock Position: You own 100 shares of XYZ stock, trading at $50.
Option Selection: You sell a one-month call option with a strike price of $55.
Delta: The option has a delta of 0.30, meaning the option price will increase by $0.30 for every $1 increase in stock price.
Theta: The option's theta is -0.05, indicating it will lose $0.05 per day.
Vega: The option has a vega of 0.10, so for each 1% decrease in volatility, the option price drops by $0.10. Understanding the Greeks provides a comprehensive view of the risks and potential rewards associated with covered calls.
Who Should Use Covered Calls?
Income-oriented Investors: Those looking for additional income streams, such as retirees, may find covered calls appealing. The premiums received from selling call options provide a regular income, which can be especially useful for those relying on investment income.
Long Term Existing Stockholders: Investors who already hold a substantial position in a stock and do not plan to sell it soon can use covered calls to generate income. This allows them to monetize their holdings without liquidating their positions.
PROs of Covered Calls
Income Generation: You earn the premium from selling the call options, providing additional income.
Downside Protection: The premium received can offset some of the losses if the stock price declines.
Selling at a Target Price: If the stock price rises and the call options are exercised, you sell your shares at the strike price, which is usually higher than the current price when the options were sold.
CONs of Covered Calls
Limited Upside: Your potential profit is capped at the strike price of the call options sold. If the stock price soars, you won't benefit beyond the strike price.
Obligation to Sell: If the stock price exceeds the strike price, you may be obligated to sell your shares at the lower strike price.
Stock Decline: While the premium offers some protection, it doesn't eliminate the risk of a significant decline in the stock price.
The Bottom Line
Covered calls are a conservative strategy that helps investors generate additional income from their stock holdings. By selling call options on stocks you already own, you can earn premiums while maintaining a measure of downside protection.
This strategy is best suited for income-oriented and conservative investors who anticipate stable or moderately rising markets. However, it comes with the trade-off of capped upside potential and the obligation to sell shares if the stock price exceeds the strike price. Understanding the key options Greeks (delta, gamma, theta, vega) can further optimize the use of covered calls for effective risk and reward management.
Post by Adam Koprucki
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By GavinMcMaster
That’s fine if you’re super bullish on AAPL and are happy with that exposure, but it’s not great diversification.
Thankfully there is a way to trade this popular income strategy and still maintain some level of diversification.
A poor man’s covered call is like a regular covered call but requires only a fraction. It’s like taking a leveraged position, so the returns in percentage terms will be amplified.
Below are some advantages and disadvantages of a poor man’s covered call over a regular covered call.
I like using this strategy with ETF’s, that way you have built in diversification.
For examples, I could set up a pretty well diversified portfolio by trading poor man’s covered calls on the following ETFS:
Bonds – TLT
Real Estate – IYR
US Stocks – SPY
Emerging Markets - EEM
With 4 underlying ETFs and not a whole lot of capital, I have set up a diversified portfolio that generates income through selling call options.
Let’s look at some examples:
AAPL
Earlier we looked at the amount of capital required for one covered call trade on AAPL stock which would be around $17,300.
Let’s compare a standard covered call with a poor man’s covered call:
AAPL COVERED CALL
Trade Date: Feb 15th, 2018
AAPL Price: $172.99
Trade Details:
Buy 100 AAPL Shares @$172.99
Sell 1 March 16th, 2018 $180 Call @ $1.60
Total Paid: $17,139
Fast forward to March 10th and the AAPL shares are now worth $17,985 and the call has only gone up to $1.71. That means the total position is now worth $17,814 for a gain of $675.
This represents a gain of 3.94%. Not bad!
AAPL POOR MAN’S COVERED CALL
Let’s now take a look at how the poor man’s covered call has performed. Instead of forking out $17,299 for 100 shares, we use an in-the-money LEAP call option.
Trade Date: Feb 15th, 2018
AAPL Price: $172.99
Trade Details:
Buy1 January 17th, 2020 $140 Call @ $43.00
Sell 1 March 16th, 2018 $180 Call @ $1.60
Total Paid: $4,140
Let’s see how this position compares on March 10th. The $140 call has increase in value from $43 to $49.50 and the short call from $1.60 to $1.71.
The total position is now worth $4,779 for a total gain of $639 which represents a percentage gain of 15.43%.
By utilizing the poor man’s covered call, we have managed to generate a similar dollar return, while using only a fraction of the capital.
Let’s now take a look at a time when AAPL stock went down.
AAPL COVERED CALL
Trade Date: Jan 29th, 2018
AAPL Price: $167.28
Trade Details:
Buy 100 AAPL Shares @$167.28
Sell 1 March 16th, 2018 $175 Call @ $4.35
Total Paid: $16,293
On Feb 9th, AAPL reached a low of $150.24 and the March $175 call had dropped to $0.50.
The net position was worth $14,974, a decline of $1,319 or 8.10%.
AAPL POOR MAN’S COVERED CALL
Let’s now take a look at how the poor man’s covered call held up.
Trade Date: Feb 15th, 2018
AAPL Price: $172.99
Trade Details:
Buy 1 January 17th, 2020 $140 Call @ $41.70
Sell 1 March 16th, 2018 $175 Call @ $4.35
Total Paid: $3,735
On Feb 9th, with AAPL trading at $150.24, the LEAP call had dropped to $31.35. With the short call trading at $0.50, the net position was worth $3,085 for a loss of $650.
This loss represents a -17.40% return on capital at risk which is worse in percentage terms than the regular covered call.
BUT, the dollar value loss is only half that of the regular covered call. Part of the reason for this is the rise in volatility, which would have given a small benefit to the long call holder.
It doesn’t always work out like this, but in both of these examples, the poor man’s covered call was the better trade. In the first instance, the poor man’s covered call made a similar return while using much less capital. In the second example, the dollar loss was much less, half in fact, than the regular covered call.
Poor man’s covered calls are one of my favorite trading strategies. Traders can achieve excellent returns, but they need to be aware that percentage losses on the downside are magnified as well.
If you want to check out a detailed example of a poor man’s covered call that played out over the course of a year, you can do so here.
Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. He likes to focus on short volatility strategies. Gavin has written 5 books on options trading, 3 of which were bestsellers. He launched Options Trading IQ in 2010 to teach people how to trade options and eliminate all the Bullsh*t that’s out there. You can follow Gavin on Twitter.
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By Kim
Managing portfolio volatility is a critical aspect of investing, and there are many strategies available to accomplish this goal. The covered call strategy is one of the most popular strategies for managing portfolio volatility. In this blog, we will discuss how to use the finest covered call strategy to manage portfolio volatility.
What is a Covered Call?
A covered call is an options trading strategy that involves owning a stock and selling call options on that stock. By doing so, the investor receives a premium (i.e., payment) for selling the option, which provides some downside protection in case the stock price falls. At the same time, the investor limits their upside potential, as they have agreed to sell the stock at a specific price (the "strike price") if the stock price rises above that level.
What is a Covered Call in the Stock Market?
A covered call is an options strategy that involves selling call options on a stock that you already own. A call option gives the buyer the right, but not the obligation, to purchase the underlying stock at a specific price (known as the strike price) on or before a particular date (known as the expiration date). When you sell a call option, you receive a premium from the buyer, which you get to keep regardless of whether the option is exercised or not.
The key to a covered call strategy is that you already own the underlying stock. If the option is exercised, you sell your stock at the strike price and keep the premium you received from selling the option. If the option is not exercised, you keep the stock and the premium, and you can sell another call option in the future if you choose.
How does the Covered Call Strategy work?
The covered call strategy involves three main steps:
Buy Stock: The investor purchases shares of a stock they want to hold in their portfolio.
Sell Call Option: The investor sells a call option on that stock. The call option represents the right (but not the obligation) for another investor to purchase the stock at a specific price (the strike price) within a particular timeframe (the expiration date).
Manage the Option: As the option seller, the investor can choose to either let the option expire worthless (if the stock price remains below the strike price) or buy back the option (if the stock price rises above the strike price). In either case, the investor keeps the premium received for selling the option.
By following these steps, the investor can reduce the volatility of their portfolio by collecting premium income from the options while maintaining some upside potential from the stock they own.
A Covered Call Strategy Benefits from What Environment?
The covered call option strategy benefits from a market environment where the stock price is stable or slightly bullish. In this environment, you can sell call options at a strike price that is slightly above the current stock price, which means that the option is less likely to be exercised, and you get to keep the premium. If the stock price does rise above the strike price, you still profit from the sale of the stock and the premium.
Advantages of Covered Call Strategy
The covered call strategy offers several advantages for managing portfolio volatility:
Downside Protection: By selling a call option, the investor receives a premium that provides some protection against potential losses in the stock. If the stock price falls, the option premium can offset some of the losses.
Income Generation: The premium received for selling the call option provides additional income to the investor, which can help enhance the overall returns of their portfolio.
Limited Risk: The investor's risk is limited to the stock price minus the premium received for selling the call option. This can provide a level of comfort for investors who are hesitant to take on too much risk.
Flexibility: The investor can choose to sell options with different strike prices and expiration dates, allowing them to tailor the strategy to their risk tolerance and investment goals.
Living off Covered Calls
One of the main benefits of using a covered call strategy is that it can provide investors with a consistent income stream. Investors can generate additional income from their holdings by selling call options on stocks they already own. By selling call options, you receive premium income, which can be used to supplement your income or reinvest back into your portfolio. This can be particularly useful for investors who are dreaming of living off covered calls and their investments in retirement.
Call Markets
A call market is a market where trading occurs at specific times of the day rather than continuously throughout the day. In a call market, investors submit orders to buy or sell securities at a particular price, and these orders are executed at a predetermined time. Covered call alerts can be particularly useful in call markets, as they can help investors identify potential trading opportunities when the market is open.
When stocks rise or fall in a call market, it can lead to the opportunity to sell covered calls for higher premiums. In a volatile market, premiums can increase, which means that you can earn a higher income from selling call options. However, it is important to be careful when selling covered calls in a volatile market, as it may increase the risk of having the stock called away.
What is a Covered Call Alert?
Before diving into the details of covered calls, it is important to understand what a covered call alert is. A covered call alert is a notification system that alerts investors when a particular stock meets certain criteria for a covered call trade. These alerts are typically generated by software programs that use algorithms to identify stocks that meet specific criteria.
A covered call alert is a tool that can help you identify potential covered call opportunities. The alert system monitors your portfolio and provides alerts when a stock meets specific criteria, such as having high implied volatility or an upcoming earnings announcement.
Best ETFs for Covered Calls
If you are looking to implement a covered call strategy in your portfolio, there are several exchange-traded funds (ETFs) that can help. These ETFs typically invest in stocks and sell call options to generate income. Some of the best ETFs for covered calls include the Invesco S&P 500 BuyWrite ETF (PBP) and the Global X NASDAQ 100 Covered Call ETF (QYLD). These ETFs offer investors exposure to a broad range of stocks while also providing the potential for additional income through the sale of call options.
Conclusion
The covered call strategy can be an effective way to manage portfolio volatility by reducing downside risk and generating additional income. However, like any investment strategy, it's important to understand the risks and potential rewards before implementing the system in your own portfolio. Consult with a financial advisor or do thorough research to ensure that the plan is appropriate for your individual circumstances and investment goals.
In conclusion, a covered call strategy can be an effective way to manage portfolio volatility while generating income. By selling call options on stocks you already own, you can reduce risk and potentially earn revenue. It is important to remember that covered call strategies involve risk and may not be suitable for all investors, so be sure to consult with a financial advisor before implementing this strategy in your portfolio.
AUTHOR BIO:
Adrian Collins works as an Outreach Manager at OptionDash. He is passionate about spreading knowledge on stock and options trading for budding investors. OptionDash ensures to offer the best Covered Call and Cash Secured Put Screener on the internet.
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By Reel Ken
Before I get into "new ground" in this article, let me recap my basic objection to covered calls.
Old News
One hopes that the investor has carefully selected a portfolio of stocks. One would also like to think that the investor's selected portfolio will, at least in their mind, outperform a simple index fund ... such as the SPDR S&P 500 ETF (SPY). For if the investor doesn't think they will outperform the broad index ... why not just buy the index and make life simpler?
And the same can be said for individual stocks, such as any of the FAANG stocks. If the investor doesn't believe their selection will outperform a broad based, representative ETF, such as the Invesco QQQ NASDAQ ETF (QQQQ), then just go out and buy the ETF.
Now that leads to my dislike of covered calls. It is not based upon a conclusion that one can or can't make money. That's irrelevant. It's more of a logical argument than a statistical argument. Simply stated it is:
If one sells a call, then it makes sense to sell a call against an underlying that is least likely to be over-run rather than end up losing money
I won't go into this in the level of detail of my previous article other than to suggest that one sell a call against an index or index based ETF rather than the specific stock the investor has so carefully chosen and expects to outperform the index.
New Approach
But enough of "old news". Let's turn our attention to more fertile ground. A "different" approach to selling calls, covered, naked or otherwise.
Let's say one wants to sell a call against the SPDR S&P 500 ETF (SPY). The first step one takes is to select the applicable strike and expiry. As I write this SPY is trading around $270.5 and let's say I'm considering selling a monthly call 1% out-of-the-money. So, I look at the November 16th expiry and a strike of $273.5. Not quite a month and not quite 1%, but we're talking concept here. After all, who knows where SPY will be when you actually read this.
But before we get into specifics, I must stress that I'm using current option prices when volatility is relatively elevated. This means that any example will look a little more dramatic than it might when volatility is more normal. Additionally, I would be hesitant to sell a call after a recent , big drop ... preferring after a big rise ... but that's another story.
The Gamble
So, using SPY=$270.50 plus current volatility plus November 16th expiry and about 1% OTM we find a premium credit of $3.60.
Now the results of this strategy are pretty easy to understand. If SPY goes down or up no higher than $273.50 then one pockets the premium of $3.60.
On the other hand, if SPY goes up higher than $273.50, then a "give-back" commences and if SPY goes above $277.10 ($273.50 strike plus $3.60 premium = $277.10) the "give-back" is total and losses will commence.
Now for SPY to go from its current price of $270.50 to $277.10 would represent a rise of slightly less than 2.5%. That, quite simply, is the gamble. In the particular market we face, today, that might be a losing gamble, but that's the gamble one takes.
The Tweak
There are multiple possible tweaks, but I'll just detail two of them. Both designed to effect a slightly different result. I suggest each reader "play" with the idea to find their comfort level and what matches their objectives. Here goes:
Instead of selling one call at a strike of $273.50 for a credit of $3.60 ... sell a ratio call spread. Now a ratio call spread is one of the simplest of the more exotic option strategies. It consists of two legs as follows;
First leg is a buy of a call. that call can be ITM, OTM or ATM. Second leg is selling twice as many calls at a higher strike. The actual strike selected for these call-writes can be selected to break-even, produce a credit or a debit. It all depends upon the objective. Now, for purposes of the "tweak" I want to improve upon the results of a simple covered call that produces $3.60 of premium at a strike of $273.50. That goal will determine the strikes for both legs.
Tweak #1
Instead of selling a simple call at a strike of $273.50 for $3.60 I employ the following ratio;
Buy a long call ITM at a strike of $269.50 for $5.90 Sell 2x short calls at a strike of $271.50 for a credit of $4.71 each for a total net credit of $9.42. Here's what happens. The net credit is $3.52 ($9.42 minus $5.90). That's close enough to the targeted $3.60.
So, If SPY drops, the minimum one gains is $3.52. I say minimum because leg #1, the long call is slightly in-the-money. So, if SPY drops below $270.5 but above $269.50, one picks up not only the $3.52 net premium credit, but some value from the long call. By example, if SPY dropped only 50 cents and landed at $270, the total gain would be $4.02 ... $3.52 from the net credit and $.50 from the long call.
Now, what if SPY rises? Well, we are still working with a net credit of $ 3.52. However, if SPY lands anywhere below the two short calls at $271.50, the long call goes further ITM increasing the gains.
So, let's say SPY moves up and lands precisely at $271.50. Well, we have the $3.52 credit plus another $2 ITM for a total gain of $5.52.
What if SPY rises above the upper strikes of $271.50. Well there is a "give- back" of the $2 ITM from the lower leg long call. If SPY rises to $273.50 the "give-back" is 100% and one is simply left with the $3.52 net credit.
If SPY rises above $273.50, the position is net short and one starts to lose the $3.52 initial credit. I SPY goes as high as $277.02, then all is lost and one ends up a loser on rises above that level. But here's the key ... they lose, but they lose no more than they would have lost on a simple covered call or naked call.
So, the result is pretty simple. The "tweak #1" will outperform a simple covered call if SPY lands anywhere from $269.50 to $273.50 and equal (minus 8 cents) the covered call on all other situations up or down.
Perhaps a graphical representation would be helpful:
Tweak #2
The concept is the same only the objective is slightly different. Instead of trying to make additional gains on advances up to the covered call strike of $$273.50, we can look to raise the break-even and loss points. So...
Buy the first leg at a strike ATM instead of ITM at $270.5. This costs $5.51. Sell the 2x second leg at a strike of $272.50 for a credit of $4.35 each and a total credit of $8.70 The net credit is $3.20 instead of a simple call-write of $3.60.
What we end up doing is gain on any rise above ATM of $270.50 up to the second leg at $272.50. The "give-back" starts at $272.50 and isn't complete until SPY= $274.50 and the "break-even" is moved upward from $277.10 to $277.70.
Here's how it looks when compared to a simple call-write and tweak #1.
Summary
With a little bit of imagination and some work one can easily find alternatives to the simple call-write .. whether the call-write is covered or naked.
I've illustrated two ratio tweaks to point out how one can tailor the outcome to meet almost any objective.
The first tweak had, as an objective, to make more if SPY didn't reach the strike point. Tweak #2 was designed to raise strike point to lesson the chances of being over-run.
Both tweaks gave up a slight bit on the lower end, but that's not a result of any inherent disadvantage. it is a result of the fact that SPY option strikes are in 1/2 dollar increments and the best one can do is get close.
There are infinite possibilities one just needs to be willing to put on a thinking cap and find what fits them.
The important thing to take away from this is ... before ... one writes a simple call ... look at the ratio spreads and determine if there's a spread that can give you a little more than "plain vanilla". In most cases it will.
Ken Reel is a well known and respected Seeking Alpha Contributor with over 100 articles. He has worked in the financial service industry for 40 years. Ken's area of expertise is risk management and complex financial products. He has been a frequent speaker, on behalf of many financial firms, to financial professionals across the country. He has extensive experience in statistics and actuarial science.
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By Michael C. Thomsett
Two primary flaws are found in covered calls, and these should be well understood by anyone decided to sell a call. First is the potential lost opportunity risk. If the underlying price rises far above the strike and the call is exercised, shares are called away – often well below current market value. A covered call writer needs to understand this risk and accept it in exchange for consistent income from the position.
A second flow is that profits are always limited. The maximum profit is the premium received for selling the call or calls; however, a very real risk of net loss also exists. If the underlying price falls below net basis, a paper loss results. This means a writer has to either realize the loss or wait it out in the hope that price will rebound in the near future. For example, a trader buys 100 shares at $40 and sells a call with a 42.50 strike, expiring in two months. Net premium received is 3 ($300). The net basis is $37 per share (purchase price minus premium received). If the underlying price falls to $32 per share, the trader allows the call to expire worthless, but now has a paper loss of 5 ($500). Should the trader sell shares and cut losses, sell another covered call, or wait it out in the belief the price will turn around?
The outcome should compare a limited maximum profit to unlimited possible losses. The risk is no greater than just owning shares, but it remains a risk just the same. A solution is to focus on underlying issues with exceptionally strong fundamentals (high dividend yield, 10 years of increasing dividends per share, annual high/low P/E between 25 and 10, growing revenue and net return, and a level or declining debt to total capitalization ratio). Strong fundamentals reduce volatility in stock prices over time, making covered calls safer than those for stocks with high volatility or erratic swings. But this is a deferred factor, not something seen to have an immediate impact:
Fundamentals matter, but it takes time for the market to recognize and fully absorb the improvement in a sector’s fundamentals. When the market is not perfectly efficient, the firm’s market value can differ from its fundamental value. (Zhang, D. (2003). Intangible assets and stock trading strategies. Managerial Finance, 29 (10), 38-56)
In other words, markets are inefficient. We hear this said a lot, but many people do not appreciate the meaning of the observation. Covered calls are not sure things and market inefficiency makes covered call writing higher-risk at times than options traders might believe. This is one reason n it makes sense to focus on very short-term expiration cycles. The longer a short option is left open, the greater the risk of unexpected and undesirable price movement. With expiration in one to two weeks at the most, time decay makes profitability more likely than the longer-term option selections.
Based on the dollar amount received for selling options, many prefer to go out two or three months (or more). But in comparing short-term and longer-term options on an annualized basis, the shorter-term option yields better net returns. In other words, selling 8 two-week options is more profitable than selling two 8-week options. The dollar value of premium can be deceptive, and the only way to make valid comparisons is to restate returns on the annualized basis. A second advantage in the shorter-term option is rapid time decay, reducing risk exposure and allowing traders to roll trading capital over many times to avoid the unexpected.
It also makes sense to avoid holding open covered calls in two conditions. First is quarterly dividend date. If a covered call is open in the days immediately prior to ex-dividend date and the call is in the money, traders can execute a dividend capture strategy, call away your shares, earn a quarterly dividend in one or two days, and then dispose of shares. This means you do not earn the dividend and you lose shares you want to keep. The second date to avoid is the day of quarterly earnings announcements. In case of an earnings surprise, the underlying can move in an unexpected way, often exaggerating the response to the surprise itself and leading to early exercise.
In any strategy, even the assumed “sure thing” of a covered call, risk assessment and equally important risk awareness should be taken into account in judging a position. What is your exit strategy with the covered call? One conservative approach is to close a position when a certain percentage of profits are realized; but options traders know that setting goals is easier than following them. It often is too tempting to hold off closing in the hope of more profits tomorrow or next week. No one can know for sure when profits will suddenly turn into losses, so setting a conservative goal and then taking action when that goal is reached, is a wise method for avoiding losses.
The lesson worth remembering in this is that there are no sure things in any form of trading. It’s true than covered calls are wonderfully consistent cash cows for traders, but anything can go wrong at any time, so traders need to (a) diversify risk exposure, (b) know the true risks to any strategy, and (c) limit exposure by time to expiration. Know when to take profits and set your rules. Then follow them consistently.
Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his websiteat Thomsett Guide as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.
Related articles:
Uncovering The Covered Call Covered Calls –Does Rolling Forward Mean Higher Risk? Leverage With A Poor Man’s Covered Call 2 Tweaks To Covered Calls And Naked Calls Dangers Of The Covered Call -
By GavinMcMaster
The investor then sells a call option over those shares in exchange for collecting a premium.
One call option contract represents 100 shares, so investors can sell multiple call options if they have a particularly large stock holding.
Covered calls have been shown to outperform pure stock ownership over the long term while also decreasing volatility.
Based on data provided by the CBOE, we can see that BXM (CBOE S&P 500 Buy Write Index) has significantly outperformed the S&P 500 over the tracking period of 1986 to 2014.
Covered calls work well on blue chip, low volatile stocks. This way you can generate a tidy sum from selling the call options and also receive a healthy dividend while you own the stock.
Here are two stocks that meet that criteria:
INTC
Intel has had a tough run of it lately with the trade war having a big impact on the stock price. There are still risk ahead for the chip maker but it seems to have put in a short-term bottom for now.
After dropping 27% in April and May, the stock has recovered and is now above a rising 20-day moving average.
Conservative traders may want to wait for a successful retest of the 20-day line before making a trade.
Volatility isn’t as high as it has been recently, but at 25% for a Dow stock, there is some value there for option sellers.
The stock also pays a nice 2.66% dividend so investors can achieve some nice income while they hold the stock.
By combining stock ownership with covered call trading, investors can further boost the income potential from this semiconductor stock.
With the stock currently trading at $47.21, traders could sell an August 21st $49 Call for $1.27.
Such a trade would forego any capital gains above $49, but would increase the income potential by another 15.90% per annum.
MMM
3M Corporation is another stock that’s had a tough run lately.
This Dow component is another stock that dropped around 27% in the April-May period.
Like INTC, the stock has bounced off the low and is holding above a now rising 20-day moving average.
MMM pays a very healthy dividend around 3.37% and is a Dividend King, having raised dividends for more than 50 consecutive years.
Implied volatility is currently around 25%, having been as low as 15% and as high as 35% in the last year.
Traders wanting to increase the yield from their portfolio could sell an August 21st $180 call for $3.85 which would add another 13.1% per annum income potential to the holding.
Join me for a webinar on Saturday, where I’ll be sharing my market analysis and also looking at more trade ideas such as this.
As always, do your own due diligence and trade safe!
Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. He likes to focus on short volatility strategies. Gavin has written 5 books on options trading, 3 of which were bestsellers. He launched Options Trading IQ in 2010 to teach people how to trade options and eliminate all the Bullsh*t that’s out there. You can follow Gavin on Twitter.
Related Articles:
Uncovering The Covered Call Covered Calls –Does Rolling Forward Mean Higher Risk? Leverage With A Poor Man’s Covered Call 2 Tweaks To Covered Calls And Naked Calls Dangers Of The Covered Call Exercise Risk Of Uncovered Calls
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By Michael C. Thomsett
1. Risks are low, but so are maximum profits
The risks of covered calls are low, without any doubt. Properly selected calls – slightly out of the money, expiring sooner rather than later – are going to yield double-digit annualized returns. But on the other side of this trade is a specific limitation of profits. The most profit you can earn on the call is the call premium; additional profits come from capital gains and dividends, adding up to a potentially substantial number. But the profit on the call itself is very limited. Even if the capital gain is a nice high number, it can only go so far. For many, the best time to open a covered call is when paper profits have accumulated already, and exercise would combine call premium with a big capital gain in the underlying.
2. If underlying declines too far, you have a paper loss
A loss is possible. Too often, traders overlook what happens if the underlying tumbles. With recent stock market volatility, traders have had a wakeup call in many cases, discovering that their sure thing was not all that sure. For example, Amazon.com (AMZN), a favorite among options sellers, was at $1,775 on December 10. Two weeks later, it had fallen to $1,350 per share, a drop of 425 points. If a trader had purchased 100 shares at $1,775 and sold a one-month ATM contract for 85, that would seem liked a perfectly reasonable buffer, under normal circumstances. But over two weeks, the loss in stock of $42,500, adjusted by option premium of $8,500, translates to a paper loss of $34,000. The stock rebounded, of course, but on that day of the drop, the once-safe covered call would have to be perceived with more caution.
3. Recovering from a loss might take time or require facing higher risks
The time required for a depreciated stock to rebound is going to vary. Amazon tends to act with high volatility, making options richer than many other choices, and potentially likely to rebound quickly. But there are no promises. Some stocks decline and stay down for a long time. For example, IBM was at over $150 per share at the beginning of October. By December 26, it ended up at under $114, a difference of 36 points, or a 24% drop in value per share. A trader selling an ATM covered call expiring in October at the strike of 150 would have made a profit of about $150. When this expired worthless the stock was worth about $130 per share. The $150 profit on the call was offset by a loss of $2,000 on stock, a net drop of $1,850. Waiting for the stock to rebound was difficult as the stock continued falling another 20 points to a low of December 24 of about $100 per share. When will this recover? Given the degree of paper loss, a recovery strategy (for example, selling uncovered puts) would expose a trader to continuing risk without any guarantee of getting back the lost value.
4. The danger of converting to an uncovered position should not be ignored
Traders learn more from mistakes and surprises than from matters going as expected. For example, executing as series of recurring trades requires diligence and observation of trade timing. For example, a trader buys 100 shares and sells an ATM covered call expiring in two weeks. One week later, the underlying has jumped 25% in value. The trader decides to take profits and sells shares. However, in overlooking the open short call, the trader now is left with a problem. The covered call has been converted to an uncovered call. Making matters worse, with the big move in the underlying, the short call is in the money – and the stock is moving up every day. Chances are that this position will be exercised, wiping out the profit on stock and more, possibly turning the entire trade into a net loss.
5. Being classified a pattern day trader has consequences
The “pattern day trader” rule is that if you execute trades on the same underlying four times or more within five consecutive trading days, you come under scrutiny and probably will be labeled a pattern day trader. Given the nature of options trading, it would not be difficult for these volumes of trades to occur. Once your broker classifies you as a patter day trader, you are required to maintain at least $25,000 in your margin account. This is bad enough; but getting the label removed requires a few steps and could be difficult if not impossible. Before embarking on a high volume of trading activity, study the rules and take steps to avoid being viewed as a pattern day trader.
6. Potential tax consequences include losing long-term tax treatment
One oddity of options taxation is the “qualified covered call” rule. You can sell a call at any strike you want; but if you pick a strike two levels below the current price of the underlying, it probably is an unqualified covered call. This means the count toward the one-year holding period for long-term capital gains treatment is tolled and will not start again until the unqualified call is bought to close. Here’s an example: You bought stock 8 months ago for $43 per share and currently it is worth $65. You sell a covered call expiring in 5 months for a 55 strike. The rationale is that premium is rich, and exercise would produce profit in both the call and the underlying. Because the total holding period at expiration would be 13 months, it would be a long-term capital gain, right? No. Because the covered call was unqualified, the count toward the one-year hold is stopped until the call expires, is closed, or gets exercised. Even if exercise occurs on the last trading day 13 months after you bought stock, the 12-point capital gain will be short-term.
Options trading is always complicated; but many traders think the covered call is easily understood and low-risk. That is true to a degree, but some potential problems can make the position less attractive. It does not have to be as complicated at it might seem, as long as you are aware of the possibilities above and take steps to avoid problems.
Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his website at Thomsett Guide as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.
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By Michael C. Thomsett
The forward roll works because a later-expiring contract at the same strike is always worth more, due to higher time value. So you can always change out the short position profitably.You can roll forward to a later option with a strike higher, in which case it is more difficult to create a net credit. However, if you are exchanging the current strike for one five points higher and you lose $200 on the deal, what happens if the later strike is exercised? You make a profit:
Extra profit on exercise, five points $500
Less: loss on the forward roll -200
Net profit $300
The system of replacing calls is quite simple. However, there are four major pitfalls possible with the forward roll of a short call. These are:
It doesn't always avoid exercise. If the ultimate goal is to avoid exercise, the forward roll is not always successful. For example, if an ex-dividend date occurs before the later call's expiration, the short call might be exercised right before ex-date, a strategy used to get the dividend in addition to a little profit in the 100 shares. Be aware of ex-dates when you roll forward and remember that exercise can happen at any time.
It might not be worth the delay. If your roll produces less than a net of $50 or so, you have to question whether it is worth it to tie up your position for another week, or more. In some cases, letting exercise happen and getting your 100 shares called away is the most sensible outcome. Compare likely outcomes and remember to compare profitability and the time required to keep your call covered.
If you don't run the numbers, you could lose on increasing the strike. Make sure you create a profitable situation when you move up one strike as part of your forward roll. For example, if your strike goes up 2 1/2 points but you lose $275 on the net change in value on the deal, you lose money.
You could create an unqualified covered call. The forward roll can unintentionally set you up with an unqualified covered call. If you are close to getting to long-term capital gains status on your shares of stock, but your roll creates a new position with a strike more than an increment below current market value, the period counting toward favorable long-term treatment stops dead. Investigate the rules for qualified and unqualified covered calls and make sure you don't lose the better tax rate in the deal. A final note: In tracking open covered calls after a roll, be sure to adjust your basis to reflect the exchange of one position for another. When you roll forward, you set up a credit, but it consists of a loss on the current position, versus a net credit created on the new position. Your basis in the new covered call has to be reduced to account for the net loss.
Example: You opened a covered call for 5 ($500), but it now is in the money and the premium is 6.25 ($625). You roll forward to a later-expiring option with the same strike, and receive $700. The net credit is $75 ($700-$625). But the loss on the original call was $125 ($500-$625). So your true basis in the net call is 5.75 ($700-$125, or $575). So in order to get a net profit, you have to be able to buy to close below that price.
Covered call forward rolling is a sensible strategy, but you have to make sure you know all of the rules, and that you have a realistic grasp of what can happen. You want to make sure you know what to expect. Remember, experience is what you get when you were expecting something else.
Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his website at Thomsett Guide as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.
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By Reel Ken
Can You Outperform the Benchmark?
Because investors seemingly take for granted their understanding of Covered Calls they have been reluctant to put them under the microscope. This article will take a little different look at Covered Calls and suggest, perhaps, a more efficient way to accomplish the same goal.
The starting point has to be portfolio makeup. Many investors construct an investment portfolio that they believe will outperform some benchmark such as the S&P500. They don’t expect each and every position in the portfolio to outperform the benchmark --- nobody’s that good--- they just believe that their particular combination will outperform. If they don’t believe they can outperform, then I would suggest their first step should be to buy an ETF such as the SPDR S&P500 ETF (SPY). Even if one has constructed a portfolio combining individual stocks and ETFs one TRUTH remains …. Either they believe their individual selections will outperform a benchmark or they should replicate that benchmark through an ETF.
Let’s start with the investor that believes they can outperform and carefully and diligently selected 20 positions. This investor now wants to 1) hedge against a down market or 2) try to create additional income through Covered Calls. Though they are hedging against a drop, let’s say they want to leave a little room for an upside and so they write Covered Calls on each position with strikes, say, 1% Out-of-the-Money (OTM).
Now, let’s say they picked the 1% OTM strike perfectly and the overall portfolio went up 1%. Great planning … or was it? No portfolio has stocks that move up exactly the same. In any typical portfolio some stocks will do better than others at different times. If everything was the same, why own more than one stock? So, if a portfolio went up 1%, it just makes sense to assume that some stocks went up more than 1%, some less than 1% and some may even have gone down.
That means that though the portfolio went up 1%, some stocks, by virtue of the Covered Calls didn’t realize the growth above 1% and were “called away”. The portfolio is left only with the “under-performers”. As a result, the portfolio didn’t realize its actual potential, though the strikes were apparently, set perfectly.
As a result of this, a carefully structured portfolio will not perform as intended if subjected to Covered Calls. Let me drive this home using a simple two position portfolio as an example. Let’s say that the Covered Calls were 1% OTM. One position goes up 6% and the other goes down 5%. The portfolio gained 1%. However, the Covered Calls capped any individual gains at 1%. As a result, a portfolio that should have gone up 1% actually went down 4%. I call this the “over/under-achiever“ problem.
Now, some will argue that they could just write the OTM strikes at different levels on different stocks. Well, if anyone can pick outperformers in their own portfolio that correctly, why not just junk the underperforming stocks and stick with the outperformers?
There is a better way … a methodology that will enable the investor to reap these excess returns and realize the outperformance they were planning on. It’s nothing earthshattering. It’s nothing difficult. It’s done all the time.
If you are not a member yet, you can join our forum discussions for answers to all your options questions.
The Covered Call Alternative
Instead of writing COVERED CALLS on selected positions, use Naked Calls against the benchmark.
So, let’s say that our investor, instead of writing Covered Calls on 20 positions, just wrote a Naked Index Call on the S&P500 Index (SPX). Well, first it’s one trade and not 20 trades. Easier to implement, maintain and less costly … not to mention many more expiry dates. It is also Cash Settled and avoids the problem of having a position being “called away”.
Let’s look at what would happen if the investor’s portfolio outperformed the benchmark and went up, say 1.2% while SPX only went up 1%. Inasmuch as their actual holding was not subjected to any call, they realized the entire 1.2% upswing. Nothing is called away. The SPX, having gone up somewhat less at only 1%, was 100% profit with no give back.
As another example, let’s say that a portfolio went up 2% and the SPX went up only 1.5%. The Naked call on SPX, landing In-the-money .5%, will reduce the overall portfolio value by .5% through a cash debit. Nothing is automatically sold. The investor can either meet that .5% using their available cash or select to sell whatever they want. But, after the smoke clears, their portfolio is still AT LEAST .5% ahead of where it would have been with Covered Calls.
I say AT LEAST because if there were substantial outperformers and some laggards as discussed earlier the net could be much less.
What if the investor didn’t want to hedge all 20 positions and just, say 1/2 the portfolio value? With individual Covered Calls one must select which positions and what strikes. With a Naked Call, just select the appropriate number of calls and it’s done.
This can be extended to individual stocks as well. Let’s sat the investor had a tech stock and wanted to sell a covered call. Well, they either believe their tech stock will outperform QQQ or not. If they believe it will, then just sell a sufficient number of calls on QQQ to mimic the individual position.
What if one has a portfolio that leans more toward small caps, tech, international, etc.? This is easily remedied by writing naked calls on multiple indices. For instance, a portfolio that leans towards small cap, could write naked calls, say 75% on SPX and 25% on RUT. Or whatever ratio reflects the investors regimen.
The Devil is in the Details
But, and this is important when writing naked calls …. Make sure the underlying benchmark (or combination of benchmarks) is representative of your actual holdings. One should avoid a mismatch … unless it is deliberate (and that’s for another article).
The next important point to keep in mind is this method works ONLY if the investor selected portfolio outperforms the benchmark. If the benchmark outperforms the portfolio, they might have been better off with COVERED CALLS. I say “might” because writing Covered Calls always runs the risk of the over/under-achiever problem and one can never know how bad it can get.
What about Covered Calls on an index ETF such as QQQ or SPY? The “over/under achiever” problem doesn’t exist as the ETF, by its very nature, “blends” the individual stocks. But there is one thing you can do to get a better experience if your portfolio is in a taxable account (not an IRA or ROTH).
When one sells (writes) an option on equities, net gain is ordinary income, regardless of holding period and taxed at the highest applicable rate. On the other hand, options on indices such as SPX, RUT and NDX are IRC 1256 contracts and afforded special tax treatment. Any net gains are 60% Long Term Capital Gains and 40% Short Term Capital gains (so called 60/40 rule). This holds even when they are sold short and regardless of holding period. The 60% afforded LTCG can mean a significant reduction in tax, especially to those in higher tax brackets.
Assuming one expects to gain on selling an option, they will pay less tax if they sell the index option (such as SPX) instead of the corresponding equity option (SPY).
Any investor that is selling options on SPY, QQQ or IWM may want to consider switching to SPX, NDX or RUT if the tax savings are significant.
Rounding out the issue, selling naked index calls does impact margin and requires sufficient trading authority. Unless the investor can manage these “hurdles”, then they might as well just default to Covered Calls and hope it works out. When all is said and done, perhaps the additional knowledge and trading authority required for naked calls is the real reason people don’t hear much about these methods.
Summary
Covered Call strategies are often taken for granted without too much thought. That might work fine for the occasional investor “playing around” or trying a few trades. However, for the serious investor that is considering a long term or repetitive strategy designed to augment income or provide some hedge, Covered Calls present some problems. Selling naked calls on a replicate benchmark through either a single index option or combination of index options will almost surely return better results.
Once you boil it all down, the Naked Call is superior BUT it tests the investor’s equity selection. That is, it’s not about one option versus another, but whether the investor has the requisite skills to assemble a portfolio that can beat a benchmark or combination of benchmarks. If the investor is a chronic underperformer maybe the real answer isn’t Covered Calls versus Naked Calls, but something else… maybe professional money managers or simple index ETFs. On the other hand, if the investor is a solid investor, they have an opportunity to even expand upon that record by abandoning Covered Calls in favor of Naked Calls.
Ken Reel is a well known and respected Seeking Alpha Contributor with over 100 articles. He has worked in the financial service industry for 40 years. Ken's area of expertise is risk management and complex financial products. He has been a frequent speaker, on behalf of many financial firms, to financial professionals across the country. He has extensive experience in statistics and actuarial science.
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