Covered calls are a popular strategy for generating income from a portfolio of stocks. While the strategy may seem straightforward, investors must decide between various strike prices and expiration dates that influence the risk of selling stock, as well as premium income and capital gains.
In this article, we will take a look at how expiration dates impact option risk and return, as well as how to choose the right expiration dates for your covered calls.
The Impact of Expiration Dates
All stocks with options have expirations listed for the two immediate upcoming months and a quarterly expiration cycle in the future. Some stocks also have two more long-term expiration dates, known as LEAPS®, and/or short-term expiration dates, known as Weeklys®.
There are two important factors at play when choosing expiration dates:
- Time Decay (Theta): Most investors know that there’s less time value built into the price as an option nears expiration, but the rate of time decay actually accelerates as the expiration date nears. This is the biggest variable when it comes to covered call returns.
- Time Investment: Investors using shorter-term covered calls spend a lot more time managing trades than those choosing longer-term covered calls. You’ll need to pick stocks, sell options, watch positions, and make adjustments to manage the trades over time.
Long-term options have the greatest immediate income potential since there’s more time value built into the price, but short-term options have the highest amount of time value per unit of time. In other words, short-term options have better static and if-called rates of return than long-term options.
You can calculate your annual percentage income from a covered call position using a formula like this:
(Premium Received / Cost of Shares) * (365 / Days Until Expiration)
Let’s take a look at an example:
Suppose that it’s January 24 and a well-known tech company is trading at $152.00. Let’s take a look at all of the available call options at the $155.00 strike price.
The example shows that the annualized income for one-day January 25 call options is much higher than the July 19 call options, at 93.81 percent versus 14.94 percent, despite the fact that the premium is $39.00 for the January 25 option versus $1,095.00 for the July 19 option. Keep in mind that it is impossible to sell an option that expires the next day all year long. Also, this calculation does not factor in the underlying value of the stock.
Rolling Monthly Options
Most covered call investors use monthly options because of their liquidity and rate of return per unit of time. While Weeklies® may provide greater income potential, most investors see monthly covered calls as a good compromise between risk, return, and time commitments when it comes to setting up trades. also, the greater liquidity of monthly options contributes to tighter bid/ask spreads reducing slippage when opening and closing the positions.
The problem is that there is a lot of management involved with implementing covered calls—even on a monthly basis:
- What stocks are best suited for covered calls?
- What strike price should be used?
- How much money should be allocated per stock?
- What do you do if the stock price appreciates?
- What do you do if the stock price drops?
- How many option contracts should you sell?
It can be challenging to run through these questions and make decisions every single month. Without a strategy in place, you may also experience variable returns each month, which makes it difficult to plan out cash flow. This is especially true for retirement investors that rely on income.
You can reduce the amount of time that it takes to manage short-term covered calls by using a well-defined strategy. For instance, The Snider Investment Method is designed to make these strategies a lot easier to execute with a well-defined system of rules rather than subjective analysis.
Using Long-dated Options
Long-dated options—between 90 days and six months—require less effort to manage, but they have lower returns and there may be a greater risk of the stock being called away.
These options make the most sense in these situations:
- Dividend timing can play a factor in annualized returns and the risk of the stock being called away.
- Long-dated options may offer greater peace of mind, which can be important for risk-averse individuals.
- Higher strike prices can be selected, enabling investors to participate in capital appreciation of the underlying stock.
Long-dated options can also be used as a stock substitute in covered call-like strategies known as diagonal spreads. While not a true covered call, the lower cash outlay for LEAPS® could make the strategy more profitable than conventional strategies that require the purchase of underlying stock.
Using a Hybrid Strategy
Some investors use both short- and long-dated options to create covered call ladders. In the bond market, ladders are a common strategy to smooth out fluctuations in interest rates. Investors might buy 1-year, 2-year, 3-year, 4-year, and 5-year bonds to diversify interest rate risk.
The same strategy can be employed for covered call strategies to mitigate stock price volatility. By spacing out stock purchases, dollar cost averaging limits volatility. More shares enable investors to sell more covered calls to generate more income over time with less volatility-driven risk.
If the covered call position is called away, you can close the position at a profit and start the process over. If there are no calls available above the cost basis, you can still sell calls against some lower-priced shares to generate an income. The idea is to reduce the risk of unprofitable trades.
The Bottom Line
Covered calls are a great strategy for generating income from an existing stock portfolio. When executing the strategy, it’s important to select the right strike price and premium for your investment goals. Well-defined strategies, like The Snider Method, can ensure consistent results over time.
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