If you own 100 shares or more in a company that does not pay dividends but that does trade options, you can still receive income from your stock by writing covered calls. When you write a call, you are selling a derivative (financial contract whose value derives from the value of the underlying stock) that gives someone else the option to buy (typically) 100 shares of the underlying stock at a specific price (strike price). If the buyer of the contract decides to exercise the option (buy the stock at the strike price), you would be obligated to sell the shares at the strike price. With a covered call you already own the shares of the underlying stock, hence the call is “covered.” In other words, you won’t have a short position in the stock if someone exercises the call option(s) you sold. In my opinion, there’s little reason not to write covered calls if you hold 100 shares or more in a stock that has options.
So what’s the catch? Covered calls can limit your gains if the stock increases rapidly prior to the expiration of the contract. For example, say Microsoft is trading around $28 a share and you own 100 shares. You decide to write a covered call for the $30-strike expiring next month. You sell the single call contract for next month, let’s say for $0.60. So you receive $60 in premium (less commissions) for the contract. Before the contract expires, Microsoft makes a surprise announcement and the stock surges $4 to reach $32 a share. Because you’ve sold the covered call for $30, your gain on the stock will be capped at $30 because of your contractual obligation to sell at that price. You will make $2.60 (the $2 increase plus the $0.60 premium), however if you had kept the stock you could have made $4 a share instead.
If you ask me, covered calls are still a great deal as long as you are selling calls that are well out-of-the money. Selling out-of-the-money means you are selling the call at a strike higher than the current stock price. You should select a strike that would give that would provide a satisfactory annualized gain if the stock hits the strike, but that also provides adequate income if it does not. In the Microsoft example, if the stock price were to hit $30, the appreciation in price and call premium would provide a total of $2.60 profit within a period of one month. $2.60 on a $28 stock is nearly 10% and on an annualized basis would provide more than a 110% return. Anyone who expects better than a 110% return investing in stocks is probably setting unrealistic expectations. I would also hesitate to call them an investor and they may be better labeled as a gambler.
Even if Microsoft weren’t to reach $30 by the time the contract expired, you would keep the $0.60 per share in premium you received and the contract would expire worthless. The following month you could write another covered call at the $30-strike for about $0.60 again (assuming the stock doesn’t make a drastic drop before then). On an annualized basis, $0.60 a month on a $28 stock is still a 25% return. That means Microsoft could stay completely flat on the year and you would still make a 25% return. In this example the covered call provides what I would consider adequate income (25% annualized) if stock doesn’t hit the strike, as well as an excellent return if the stock does hit the strike (110% annualized).
However, if Microsoft were to experience a drastic drop, say down to $20, the $30 call for the following month would not pay nearly as much (maybe even only $0.05). If a stock has dropped well below your cost basis it may not be worth it for you to write covered calls, unless you are okay with the possibility of realizing a loss. Let’s say Microsoft does drop down to $20 the following month and your cost basis was $28 per share. In order to receive a similar amount of premium as the prior month, you would probably have to write the $22.50 call instead of the $30 call. If you were to write the $22.50 call, receive $0.60 in premium, and the stock were to rally, you would be in big trouble. If the contract expires and Microsoft is priced higher than $22.50, you would realize a $4.30 loss ($22.50 sale price minus $28 cost basis plus $1.20 premium from the calls written over the period of two months). If the stock were to up more than $23.70 ($1.20 above the $22.50 strike), you would have realized more loss than if you would have just held onto the stock without writing the second covered call.
You do have to be careful when the stock is well-below your cost basis and you perform covered calls. Many investors write calls as soon as they buy the stock. For this reason, a covered call strategy is also sometimes also referred to as a buy-write. Performing a buy-write is one way of ensuring you receive an acceptable premium in terms of your cost basis. Please note that this strategy can just as easily be used with stocks that pay dividends as well as stocks that do not. You will likely receive more income from covered calls than you would from dividends anyway, so certainly the strategy applies to dividend stocks as well. In fact, Microsoft does pay a dividend. However, at less than a 2% dividend yield, the dividend income pales in comparison to the income covered calls on Microsoft could provide.
If it sounds like something you’re interested in investing in, but would rather have someone else manage it, there are actually a few buy-write index funds that use the strategy. For example, the iPath CBOE S&P 500 BuyWrite Index ETN (ticker BWV) performs buy-write transactions on S&P 500 stocks.
As you can see, the index fund has tended to outperform the S&P 500 during the time frame displayed, since the covered calls provide some income to offset losses. It is also interesting to note that between the middle of September of 2007 and the middle of October of 2007, the S&P outperformed the fund. This is because the S&P experienced a drastic rally in this period and the gains in the fund were capped by the covered calls. The S&P increased about 6% during this period and the fund only increased by about 2%. However, shortly after the rally the S&P it also experienced a steep drop. The iPath CBOE S&P 500 BuyWrite Index performed much better during that period. The index fund lost about 3% but the S&P fell about 10%.
If you are long on stocks and/or index funds, you should definitely consider adding covered calls as part of your overall investment strategy. Disclaimer: The stock and index fund mentioned in this article are provided for informational and illustration purposes only. The securities and derivatives discussed are for your edification and are not intended to be recommendations. If you are interested in learning more, I highly recommend reading more about options. The Options Industry Council has a lot of excellent information about options, covered calls, and other strategies as well.
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