January 21, 2010, 5:00 am

A look into options strategies: Covered call

by: The Financial Blogger    Category: Investment, Market and Risk,Trading
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Equity options are products that are used increasingly because they add more flexibility to a portfolio. We gave a brief crash course for options and one of the discussed strategies is covered calls. For many investors, this can add a few percentage points to your net return on an annual basis. The most important thing to remember is to remain disciplined (as most trading strategies would call for) and not get greedy.

How it works

If you own a typical portfolio, you probably own several stocks. In our example, we will look at someone who owns Royal Bank of Canada (RY) stock. As I write, it trades at $55.20CAD. Imagine an investor who owns 1000 shares of RY and does not intend on selling these shares for the moment.

In a covered call strategy, this investor will sell 10 contracts which are currently worth $0.65 (each option contract is equivalent to 100 shares). This will entitle the buyer of the options to buy shares at the strike of the option.

A covered call is basically selling the right to buy your stocks to someone else. We will take a look at APRIL 60 CALLS. This gives the buyer the right to buy RBC stocks at $60 on expiry. And so the investor might have to sell his stock at $60. For this option sold, you receive $0.65 x 10 (contracts) x 100 (options multiplier) = $650

-If RBC is worth $58 at expiry, you will have received the $650 and the options will become worthless to the buyer – you can restart the strategy.
-If RBC is worth $60 at expiry, it will be the exact same thing.
-If RBC is worth $62 at expiry, you will have received $650 and will be forced to sell your shares at 60$.


As you can see, as long as you select a “low strike”, you will end up getting more money than if you only had your stock position.

Even if your shares do climb a lot and you miss out on some of it, you will have profited.

Upside and downside

The upside is that if you select the correct strikes, you will add cash flow to your portfolio. You can do this 3-4 times per year on most positions and make a few thousand bucks.

The main downside is that if the stock goes up by a lot very quickly, you will lose out on some of the rise. For example, if the stock goes up 15% in 3 months, you could end up making only 7-8%… Which is not that bad is it? That is why this is called a covered call. You do not have much risk besides losing out on potential gains, which are extraordinary. I know of many managers who are able to get big returns every month thanks to this method.

Risk involved

One of the main risks of this strategy is becoming greedy. If you want to collect too much, you will trade lower strikes and by doing that you:

-increase your payout (interesting)

-Increase the chances your option will be called (and that you will lose on potential gains) – less interesting.

Overall, this is a very safe strategy because it has so little downside risk. It must be used with caution like any other trading strategy.

Payoff

Here is a graph of the covered call payoff strategy:


Please feel free to ask questions, I know this is not straightforward but used with caution, it can make a big difference to your returns.

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Comments

what happened to dividends from the stocks owned? is there a different strategy between low dividend and high dividend stocks?

Interesting. It’s not a field I am knowledgeable. Are there alternatives if you are getting exercised? Are you absolutely forced to sell your stocks?

As I can analyze, better go into this strategy only if stock that you are owning is not too volatile? the more the stocks moves, the less profitable you will be right?

Thank you.

Fascinating topic! But I have a few questions regarding writing covered calls…

What type of stock would it be a bad idea to write a covered call? Do you suggest to use this strategy with ETFs as well? Do we need to watch out for the stock’s liquidity? Or the options liquidity?

I believe the options premiums collected can be reported as Capital Gains as well (instead of 100%-taxable as income)

Covered call is quite safe and good to use, especially combined with put options or purchases near the bottom

Most of my covered calls don’t get called, except Dec 2009, some in my favour, some aren’t e.g.
RIMM was called at $70, now it’s $65, so I am better off
VISA was called at $80, now it’s $85~$88, so I’m worse off

but then, V was included in the S&P 500, who could’ve predicted that :(

Options premium will include the volatility premium (so same April 2010 call, RIMM has higher premium than KO coca-cola), only thing you want is trading volume!! gotta be there

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@John – Since most exercises occur at expiration, you can always buy back the option before the expiry and avoid being “exercised”. But since it can happen prior to that date, no you cannot be 100% certain.

And about long for volatile stocks, you could argue both ways but I would say that the more volatile the stocks the more:

-chances of being exercised
-but also the better payoffs

As for dividends, it is a bit tricky but basically you need to account for these.

Sorry for my questions: if I’m long stock, am I entitled to my dividends if I’m shorting options? How can you account dividends in my decision? is there a different strategy between low dividend and high dividend stocks?

Thanks again!

[...] week, I did a brief introduction to an options strategy that can be used to get additional returns with little downside risk. Today, I will take the time [...]

I am glad to see a positive look at covered call writing. I have been doing covered calls since options were extended to many stocks back in the 1970′s. By establishing clear goals and objectives as well as putting in place a covered call writing strategy, I have always be able to outperform buy and hold strategies on stocks. While it is often true that the stock will shoot up past your strike leaving your covered call in the money, I have found that this is to be welcomed as it forces the investor to take profits, reassess the stock for further covered call writing as well as consider other stocks. The investors who fail at covered call writing strategies are those who are not long term call writers, and instead fluctuate between buy and hold and call writing. They often write their calls when the stock is in a decline rather than writing their calls consistently month to month gathering up small monthly premiums which result in an ever increasing cash cushion which they can use when the stock falls. Through covered call writing I have never had less than 12% return a year on a stock and many times almost double that amount. Through this building of a cash cushion, I look forward to my stocks pulling back so I can purchase additional shares with my cash on my favorite stocks. I have on my site at http://www.fullyinformed.com current trades as well past trades showing the returns available through a consistent approach to covered call writing. Go to my retirement portfolio where I am only able to sell covered call options due to Canadian tax laws. Imagine 12% a year every year over a 10 year period or 20 year period! The cash income I build up gives me confidence to add to my favorite stocks, when events like fall 2008 or early 2009 happen, and it looks like the financial world is going to end. While it is true that covered call writing offers only limited protection in a down market, the strategy still provides income during a severe downturn and I have found during severe downturns that the income made is much greater as the volatility of the market pushes up option premiums. My trades on my site show that setting clear goals and objectives as well as staying consistent will beat buy and hold every time.

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