What is a Covered Call?
A call option on an underlying stock gives the holder of the call the right to purchase the stock at a fixed price (the strike price) on or before a fixed date (the expiration date). A covered call position is when an investor owns stock and sells call options on that stock. A covered call investment strategy is a conservative strategy that can be utilized by any investor and may be practiced in a retirement account.
Covered call writing will tend to outperform stock ownership in any market except a strongly rising one and covered call writing tends to be less risky than stock ownership in all markets. Covered call writing reduces the volatility of one’s portfolio, meaning one will tend to lose less in bear markets and make less in bull markets than a buy and hold strategy. There is empirical evidence that over the long run a portfolio of covered call writing produces returns commensurate with buying and holding stock with less volatility than holding stocks alone.
How does one make money using a Covered Call Strategy?
Covered call option writing as practiced by Hardy Financial Planning, Inc. involves simultaneous purchase of stock and sale of a call option on that stock, normally at a strike price slightly higher than the purchase price and approximately one month remaining until expiration. Sale of the call option generates cash (the premium) that immediately goes into the brokerage account, effectively reducing the purchase price of the stock. If the stock is above the strike price at expiration, the option is “assigned”, which means the purchaser of the call option buys the stock from the investor at the strike price. Since the strike price is normally higher than the purchase price, the stock is sold at a profit, and the total profit on the position is the profit on the stock plus the option premium obtained when the call was originally sold.
What if the stock is not above the exercise price at the time of expiration? In that case the option expires and the seller of the option keeps the option premium and still owns the stock. At that point the investor can sell another call on the same stock and repeat the process. This process can go on month after month until the stock either rises above the strike price and is called away, or the stock declines in price to the point where a call can no longer be sold at the original strike price.
What is the risk in using a Covered Call Strategy?
This brings up the risk aspect of selling covered calls. An integral part of a covered call strategy is ownership of stock and stock prices go up and down. A covered call strategy is less risky than buying and holding the stock since the sale of the call brings in a premium that effectively reduces the cost basis of the stock, so even if the stock price goes down, the loss is less than a simple buy and hold situation. Nevertheless, when a stock goes down, there may be a paper loss that is greater than the premiums collected by selling the calls, causing a drop in the market value of the portfolio.
An integral part of a successful covered call strategy involves how one addresses the situation where a stock drops significantly in price. Some of the strategies for recovering when the price of the underlying stock goes down significantly include buying the options back at a profit and waiting for the stock to recover, rolling the options forward (buying back the call and reselling a call with a more distant expiration date), and purchasing more stock at a lower price, reducing the average purchase price, and selling call options at a strike above the new average price. Of course part of a complete strategy includes trying to avoid this situation in the first place as much as possible by careful stock selection.
As long as a company does not go bankrupt, it is probable that the price will stabilize or move back up to some degree, allowing ongoing sales of calls and eventual assignment of the shares at a profit. This is especially true of the stock has a solid business and financial base. Hardy Financial Planning, Inc. uses a variety of screens for financial and business strength when selecting stocks for inclusion in a covered call strategy including screens that are predictors for bankruptcy.
How does one protect against the risks?
Most of the return in the covered call strategy employed by Hardy Financial Planning, Inc. is generated at the outset when the call option is sold. The higher the price of the option (compared with the value of the underlying stock), the greater the return (assuming the stock is eventually sold at a profit). This is where one of the basic risk – return decisions must be made. Stocks can be screened for a high call premiums leading to covered call positions that generate the maximum amount of cash on sale of the call. The difficulty is that stocks with high call premiums have those high prices because they are very volatile, meaning they are likely to make large moves up or down in the near future. A large downside move leads to a situation where calls may not be able to be sold at the original strike price and the investor either must wait for the stock to recover or purchase more of the stock to obtain a lower average purchase price. A relatively high risk of this happening to some of the stocks purchased is inherent in this approach.
A modification of this approach is to first screen stocks for stability – stocks that are considered undervalued and which have high ratings for strong financial stability. This minimizes (but does not eliminate) the risk of rapid and significant drops in prices, however these stocks, being less volatile, tend to have call options with relatively lower premiums. As in every aspect of investing there is a relationship between risk and return.
How is a Covered Call Strategy like owning bonds?
Another way to understand covered calls is to consider the difference between a stock and a bond as an investment. Although some stocks do pay some amount of dividends, stocks are normally purchased in anticipation of price appreciation. Thus the current market value of a portfolio of stocks is the primary indication of the successfulness of the approach. Bonds, on the other hand, are purchased primarily for the income they generate. Bond prices move up and down as interest rates change, however holders of bond portfolios primarily look at the cash the portfolio generates and the current market price of the portfolio is normally a minor concern. Part of the reason is that as long as the issuer of the bond does not go bankrupt, the bondholder can be assured of getting their principal back at maturity. That maturity may be 2, 5, 10 or 30 years and what primarily matters to bondholders is the annual cash income, not portfolio value.
A covered call strategy can be though of as a hybrid of these two approaches and sometimes this approach is called a “synthetic bond”. Instead of purchasing a bond, where one’s cash is tied up for set period (2, 5, 10 or 30 years) but the bond generates cash flow, one buys stocks and sells covered calls. The sale of calls generates a cash flow similar to a bond, but is normally larger than the cash flows generated by a bond. Most of the principal is not tied up for years, but returns to be reinvested over a time frame that typically averages months, not years. Some proportion of the invested capital is freed up in less than a month when the stock rises above the strike price and the call is assigned and that cash is immediately invested into another covered call. Sometimes the stock remains in the same trading range as when it was purchased, in which case calls are sold on the same stock month after month. Eventually the stock is assigned and the principal is available for reinvestment.
There will be times when a stock will go down significantly in price or continue to drop slowly for months on end. In this case one may choose to wait for the stock to come back, in which case no income may be generated on that portion of the portfolio for some period of time. Or one may purchase more stock at lower prices. If more stock is purchased at lower prices, then calls can be sold on the stock generating income. In these cases, it may be a number of months or even years before the stock is eventually assigned at a profit and the principal recovered.
How relevant is Market Value?
While a bond typically ties up principal for years, most of the principal in a covered call strategy is turned over in a few months, with only a small portion being tied up for longer times. Nevertheless, some of the stock positions may carry paper losses for a significant time and during that time the market value of the portfolio is reduced. With a stock portfolio, a reduced market value signifies the strategy of purchasing for appreciation may not be working. With a bond portfolio, a reduced market value is not nearly as relevant as the ongoing cash flow, which was the reason for purchasing bonds in the first place. In a covered call strategy (a synthetic bond), market value is not relevant to the cash flow being generated as long as there is a reasonable level of confidence that stocks whose prices have significantly dropped can eventually be sold at a profit, especially if they continue to generate income.