A Covered Call is a popular financial strategy, but what exactly does it entail?
A Covered Call is often used by investors seeking to generate a consistent income stream. It involves owning or buying shares of a stock, and then selling call options on those shares.
Think of it this way: you own a house (the stock), then rent it out to a tenant (the buyer of the option) for a specified period. Your rental income is akin to the premium received from selling the call option.
Sounds simple, doesn’t it? But there’s more to the strategy than just that – because it could also be a part of the Wheel Strategy.
How Does a Covered Call Work?
To understand the core principles of a Covered Call, let’s look at an example. Say you own 100 shares of XYZ Corporation, currently trading at $50 per share. You decide to sell one covered call option with a strike price of $55 and an expiration date of three months. In return, you receive a premium (income) of $200.
Now, there are three possible scenarios:
- How and When to Buy a Covered Call to Close the Position?
There are several reasons why you might want to close a covered call by buying it back.
- To protect profits: If your stock has risen significantly and you foresee it continuing to rise beyond the option strike price, you might want to buy back your call option to prevent the stock from being called away, thus protecting your upside potential profits.
- To avoid further Loss: If the stock’s price has significantly dropped and you believe it may continue to fall, it could be beneficial to buy back the call and sell the stock to avoid further losses.
- To avoid assignment: If you want to keep your stock and you’re worried that it might be called away due to an approaching expiration date, buying back the option can prevent this from happening.
- Free up the stock for another covered call trade: if the call is nearing its expiration date and is out of the money, you might decide to buy it back to close out the position and free up the stock to open for another covered call trade with a different expiration.
Covered Calls for Short-Term Traders and Long-Term Investors
Covered calls can be a useful strategy for both short-term traders and long-term investors.
For short-term traders, covered calls provide an opportunity to generate income from their existing stock investments while also taking advantage of potential price movements through selling short-term calls.
For long-term investors, covered calls can help enhance their overall returns by generating additional income from their stock holdings without having to sell the underlying shares. Additionally, if the stock price does not increase significantly, the investor retains ownership of the stock and can continue to earn dividends.
In an article by First Trust Portfolios, it is stated that covered call writing tends to outperform the S&P 500 unless the stock market returns are above 10%.
The data clearly shows that incorporating covered calls into your trading and investing strategy can be beneficial for both short-term traders and long-term investors.
What are the Benefits and Risks of a Covered Call?
Like any investment strategy, covered calls come with their own set of benefits and risks.
Benefits of a Covered Call:
- Income Generation: Selling covered calls is an excellent way of generating additional income, especially when the stock market is moving sideways. You could continue to write covered calls without having your stock getting called away.
- Downward Protection: The premium received from selling the call option can help offset a decline in the stock’s price. This provides some level of protection against a downward move in the stock.
- Potential for Profit: If the stock’s price stays below the strike price of the call option, you get to keep both the premium from selling the call and the stock price appreciation. This can lead to a higher overall return compared to just owning the stock.
Risks of a Covered Call:
- Limited Upside Potential: If the stock’s price rises above the strike price of the call option, your profit is limited to the strike price minus the stock’s purchase price plus the premium received.
- Potential for Loss: If the stock’s price drops substantially, the premium received from selling the call option may not be enough to offset the loss from owning the stock.
- Overwriting Risk: There is a risk that you may have to sell your stock if the call option is exercised. If the stock’s price is above the strike price at expiration, the call option will likely be exercised, forcing you to sell your stock at the strike price.
What is Poor Man’s Covered Call?
The Poor Man’s Covered Call is a variation of the basic covered call strategy, but instead of buying the underlying stock, you buy a long-term call option. This allows traders with smaller accounts to take advantage of the benefits of a covered call without having to purchase 100 shares of the underlying stock.
In this strategy, you would typically buy an in-the-money LEAPS (Long-term Equity AnticiPation Securities) call option with a strike price below the current stock price. Then, you would sell short-term out-of-the-money calls against it to generate income.
For example, let’s say XYZ stock is currently trading at $50 per share. Using the Poor Man’s Covered Call strategy, you might buy an in-the-money LEAPS call option with a strike price of $45 and an expiration date one year in the future. Then, you would sell monthly out-of-the-money calls with a strike price of $55.
This strategy can be particularly useful for those who want to participate in covered calls but don’t have enough capital to buy 100 shares of the underlying stock. It also allows traders to take advantage of the leverage provided by options, as LEAPS contracts are typically cheaper than buying the underlying stock.
Benefits and Risks of Poor Man’s Covered Call
As with any trading strategy, there are both benefits and risks associated with the Poor Man’s Covered Call.
- Limited downside risk: because you own a long-term call option, your risk is limited to the amount you paid for the option.
- Income opportunities: by selling short-term calls against your long-term call, you can generate recurring income.
- Leverage and lower capital requirements: as mentioned, using LEAPS contracts provides leverage and allows traders with smaller accounts to participate in covered calls.
- Potential loss of opportunity: if the stock price rises significantly, you may miss out on potential gains as your short-term calls will likely be exercised.
- Limited upside potential: while you can still profit from the underlying stock’s increase in value, it will be limited to the strike price of your long-term call option.
- Time decay: since you don’t own the underlying stock, you are exposed to time decay on your long-term call option.
- Dividend risk: if the underlying stock pays dividends, you could miss out on potential income as your short-term calls may be exercised before the ex-dividend date.
Best Stocks for Covered Call
When selecting stocks for covered call strategies, it is important to consider the following factors:
- Highly liquid stocks: choose stocks with high trading volume and open interest in their options contracts to ensure ease of buying and selling.
- Low volatility: select stocks that have stable price movements rather than high volatility to reduce the risk of large losses. Even though high volatility could mean higher premium prices for short-term calls, it also increases the likelihood of them being exercised and potentially missing out on further gains. Or the stock price could plummet, leading to significant losses.
- Dividend-paying stocks: stocks that pay regular dividends can provide additional income through covered calls, but be aware of potential dividend risks as mentioned above.
- Undervalued stocks with upside potential: selecting undervalued stocks can increase the chances of prof
- Strong fundamentals: look for companies with solid financials, a history of consistent earnings and dividends, and positive market sentiment.
- Diversification: consider diversifying your portfolio by choosing stocks from different industries or sectors to reduce overall risk.
Here are some example stocks that may be suitable for implementing a covered call strategy:
- Apple Inc. (AAPL): Known for its high liquidity and stable dividends, Apple can be a good choice for a covered call strategy.
- Microsoft Corporation (MSFT): Microsoft’s steady price movements and robust financials make it another favorable candidate.
- Johnson & Johnson (JNJ): This company’s strong fundamentals and consistent dividend payouts can be beneficial for covered call traders.
- Procter & Gamble Co. (PG): With its low volatility and stable dividends, Procter & Gamble can be an apt selection.
- The Coca-Cola Company (KO): Coca-Cola, with its global market presence and consistent dividends, can be an attractive choice.
Please note: These are just examples and not recommendations. Always conduct thorough research before making any investment decisions.
The Wheel Strategy
If you’re already convinced of the efficacy of the covered call strategy as a tool for income generation, then prepare to be further amazed.
Let me introduce you to another income-generating options strategy – the Wheel Strategy. This strategy is akin to an upgraded version of a covered call, providing traders with additional avenues to accumulate profits.
With the Wheel Strategy, not only are the benefits of a covered call strategy preserved but the potential for income generation is also enhanced. Intrigued? Check this blog post about the Wheel Strategy.