Selling a covered call is one of the most popular strategies among option users, both institutional and retail. In the US the strategy is considered fairly conservative and it's even allowed in Individual Retirement Accounts (IRAs). On this side of the pond, however, investors are yet to discover the benefits of this straightforward option strategy.
Anatomy of a covered call
As a review, the strategy consists of long stock and short call. One contract will be sold for every 100 shares of stock investor owns in their account. Hence the term "covered" call. By selling a call against a stock, the investor receives money from the buyer of that call. By collecting that income the stock owner obliges himself to deliver their shares to the "potential" buyer. Frequently, that buyer has no intention of buying – they are simply looking to make a quick profit from price movement.
Covered Call Benefits/Risks
For the seller of a covered call there are a few benefits. In a low or negative interest rate environment, that investor can create cash flow on monthly basis on the stock they own or they'd like to own. It's like creating a synthetic dividend on that stock.
Sometime we fall in love with our stock and cannot depart from it, even after the price is falling. The most we can lose of course is what we put in.
Example, investor purchased 500 shares of Wells Fargo at $50 for a total net investment, excluding brokerage fees, $25,000.
The most that investor could lose is the price he paid for Wells Fargo shares ($50). So the smaller the cost for that position, the less the maximum loss for that position would be.
By employing on systematic basis a covered call strategy investor could help his overall position and even improve it over time. If that investor extended to a call option 35 days out, slightly above the current market price of WFC (at the time of writing $44.88), he could sell a call option with a price of $45 and collect $1.50 or $150 for every 100 shares he owns. The cash goes into his account and reduces his cost basis in the stock from $50 to $48.50. That's a 3% reduction!
What's the worst that could happen in a covered call?
The worst that could happen to that investor is for the shares to continue to fall. Better outcome will be for the stock to stay at current levels or move higher. An investor who wants to stay in the stock could roll out the covered call and adjust it according to their current market view. That's the beauty of using options as a strategic tool. For more info on covered calls, please check out our educational webinar on covered calls from May 16 here
, or at the Options Industry Council
Setting up Facebook covered call
Shares of Menlo Park, a California-based social media company, are up some 20% year-to-date and have been trading in a steady, predictable pattern. More recently the shares seem to change hands between a high of $132 and $126.
If you own shares at current levels or lower, this pause in the overall uptrend, could be the right time to sell a covered call and enhance your overall return in the position.
The first question to ask is how much time should you sell and what price? Most investors will sell 30-50 days out as there is enough time premium than shorter dated ones. Some will also extend as far out as six months. There are many ways to skin a cat and options are no exception.
The strike price selection depends on your market view. If mildly bullish, don't expect shares to rocket up, you could sell a technical level such as resistance or 2%–3%. If very bullish, however, and you feel that the price will explode, a covered call is not the right strategy.
For the trade example above we would sell November 130 calls for $4 per contract (100 shares) against 100 shares of Facebook at $127.31
Management and risk description
The risk in a covered call lies in the underlying stock price and not on the short call that you have sold. Remember to purchase the shares first.
Investors can make adjustments at any time during the life of the option, based on their market view of the underlying shares. We will provide a couple of updates, but there's no need to be reactive with this strategy. Let the paint dry.
You can also close out of this at any time. Simply buy back the same call option you sold.
Underlying price (FB) @ $127.31
Trade: SELL -1 FB 18 NOV 16 130 CALL at $4 Limit
Trade Risk: purchase price - premium or $127.31 - $4 = $123.31 => new cost basis in the stock and also (breakeven at expiration)
Return on Risk, if called out at $130 = 123.31/$130 = 9.5% over 52 days or 28% annualised
Entry: Today, first must purchase the shares, if you don't have them already
Stop: no stops
Target: to get the most of this strategy, shares should be at $130 or above
Time horizon: medium-term
— Edited by Clare MacCarthy
Non-independent investment research disclaimer applies. Read more