Many investors prioritize income and stability over maximizing gains. While fixed-income and dividend stocks address these goals, covered calls are an increasingly popular options strategy for investors that want to boost their equity portfolio’s income while reducing downside risk. And it involves less risk than many other options strategies. In this article, we’ll briefly review how covered calls work and examine three covered call examples the best to worst cases. Then, we’ll show you some tips for managing these positions to mitigate risk.
A Brief Intro to Covered Calls
Covered calls are a popular way to generate income from an existing long-stock portfolio. The strategy involves selling/writing a call option on a current long stock position, thereby “covering” the option with the underlying shares. By selling these options, you earn upfront cash, known as the premium, in exchange for giving up potential upside.
Most people sell covered calls to generate income from the option premiums. The extra income can enhance the overall return on the investment and provide a buffer against some losses. And if the stock price remains relatively stable, the investor can achieve these benefits while still retaining ownership of the shares.
The primary drawback is that covered calls limit upside potential. If the stock price increases significantly, you will miss out on the gains beyond the strike price. While the income you generate from the premiums can help offset some of this risk, the stock market’s long-term bullish bias means you’re likely sacrificing some returns.
#1. Generating the Most Income
Suppose you own 100 shares of ABC, currently trading at $50 per share. You decide to implement a covered call strategy by selling one call option contract with a $55 strike price and an expiration in three months. In exchange, you receive an immediate $2 per share premium, representing a 16% annualized yield ($2 * 12 months / 3 months = $8).
Over three months, ABC’s stock price gradually rises to $54 per share but doesn’t quite reach the strike price. As a result, the option expires worthless, and you keep the $2 premium you received from selling the option. Moreover, you still own the 100 shares of ABC and have a 4% unrealized capital gain on the underlying stock.
#2. Missing Out on Capital Gains
Suppose you own 100 shares of DEF with a $70 per share price. You sell one call option contract with a strike price of $75 that expires in four months. As a result, you receive a $4 per share premium, representing a 17% annualized yield.
During the four months, DEF dramatically outperforms your expectations. The stock price steadily rises and eventually reaches $80 per share, surpassing the $75 strike price. As a result, the option buyer exercises the option and purchases the shares from you at $75. So while you’ve earned $5 per share, you missed an additional $5 capital gain.
One note, almost all option exercises happen at expiration. So a stock’s price can exceed the strike price during your holding period. An option buyer won’t immediately exercise their option as soon as the market price exceeds the strike.
#3. The Worst Case Scenario
Suppose you own 100 shares of XYZ at $80 per share. You sell one call option contract with a strike price of $85 and an expiration date set two months in the future. In exchange, you receive a premium of $3 per share, representing a 22.5% annualized yield.
Unfortunately, XYZ experiences significant headwinds, and the stock plummets to $60 per share. Since the stock is significantly below the strike price, you don’t have to deliver any shares to the buyer, but you experienced a 25% unrealized capital loss. And you still have a significant ~21% overall loss despite keeping the premium.
Managing Covered Calls
These scenarios illustrate the three possible outcomes from the covered call, but they assume you hold the option until expiration. Of course, there are many ways to better manage these positions based on the underlying stock’s price movements. For instance, you could roll up or roll out the covered call to give yourself more time or price leeway.
Some popular risk management techniques include:
- Roll Ups – Rolling up involves buying back the current call option and selling a new one with a higher strike price. By rolling up, investors can capture additional premiums and potentially benefit from a higher strike price if the stock rises.
- Roll Outs – Rolling out involves buying back the current call option and selling a new one with a later expiration date. By rolling out, you can provide additional time for the stock price to recover or move in a favorable direction – but at a potentially higher cost.
- Collars – A collar strategy involves adding a protective put to a covered call to limit potential downside risk. Essentially, the put option acts as insurance, protecting from a significant price decline. But it also adds extra cost and reduces your income.
- Monitoring – Regularly monitoring positions and having predetermined exit strategies can help mitigate risks. For example, you might have a specific price target or stop-loss order to close the position if the stock moves a certain way.
- Diversification – Spreading investments across different stocks and sectors can help mitigate the risk of any single stock impacting your entire portfolio. More broadly, these risk reductions can help improve your overall risk-adjusted returns.
While these strategies can help mitigate risks, you should carefully consider the risks associated with covered calls. In particular, you must weigh the cost of missing out on upside potential with the benefit gained by generating immediate income and protecting against some losses.
The Bottom Line
Covered calls offer a compelling approach to generating income and managing risk. By implementing various risk mitigation strategies, such as rolling options, employing collars, and diversifying a portfolio, you can enhance the effectiveness of these strategies.
If you’re interested in covered calls, Snider Advisors provides a free e-course to help you get started. You’ll learn everything from the basics of covered calls to how to manage positions depending on market conditions. Or, if you’re interested in a hands-off approach, contact us to learn about our asset management services.