Covered call writing for savvy long-term investors

Covered call writing for savvy long-term investors

How to obtain long-term above-average returns with moderate risks

KEY POINTS

• Covered call writing of dividend stocks is the best strategy for conservative investors to obtain long-term above-average returns with moderate risks.

• You create a covered call when you buy (or own) shares of stock and write (sell) the exact amount of calls on these shares.

• The premium you receive from writing the calls is your compensation for taking on the obligation of selling the stock at the strike price – the price at which the shares can be bought – if the call gets exercised.

• When a call is not exercised, dividends solely belong to the stockholder/call writer.

• Covered call writing is a more flexible and dynamic strategy than most people realize.

• Covered call writing is also ideal for the typical investor to get started with options.

Introduction: Why we like covered calls

Covered call writing tends to be a relatively low maintenance strategy, partly because the individual trades have better than 50/50 odds of making a profit and partly because the positions tend to garner income over time.

Managing a covered call portfolio offers an excellent experience for branching out into other option trades (such as put writing, call and put buying, and spread trading).

Another feature of covered call writing that can make it attractive to the average investor is that most US brokers allow its use in Individual Retirement Accounts.

If you are interested in getting started with covered calls, your “IRA” is probably the ideal place to start, partly because you eliminate the tax consequences of profits from selling premiums or of significant gains on long-held stocks.

In Germany, covered call writing is not yet widely used by private investors, probably because banks like to keep that business.

Covered calls: Doing the math

Because covered call writing involves both stock and short call positions, covered calls can be more complicated than stocks alone. However, if you understand a few simple calculations, you can quickly master covered call writing and the dynamics of their management.

You create a covered call when you buy (or own) shares of stock and write calls on these shares. The premium you receive from writing the calls is your compensation for taking on the obligation of selling the stock at the strike price if the call gets exercised. Your reasons for buying (or holding) a covered call are; (1) you like the stock, and (2) at the same time, you feel that the premium well compensates you.

Depending on the strike price of the call, a covered call can be bullish (strike price above the stock price), neutral (strike price equal, or close to, the stock price), or defensive (strike price below the stock price).

We show three different examples of writing 59-day June covered calls on United Healthcare (UNH) with the stock at $44.00; the out-of-the-money $46 strike covered call at $0.85, the at-the-money $44 strike at $1.77, and the in-the-money $42 strike covered call at $3.05.

In all these examples, we assume we keep the stock at expiration and repurchase the call if it ends up in the money. (Letting the stock be called away at the strike price will give you the same gain and loss at expiration, with the main difference being that you will no longer own the stock.)

Let us look at the out-of-the-money covered call first. Here we get to keep the entire premium as long as the stock is below this $46 strike price. This is an excellent strategy for investors who want to own the stock but want an extra income of $0.85 per share. At expiration, the stock would have to end above $46.85 (i.e., the strike plus the premium) for the stock position alone to have done better than the covered call.

Next, we look at the at-the-money covered call, a position in which we are moderately bullish on the stock and like the income from the premium. We take in $1.77 or $177 on one covered call struck at $44. Although you can only earn this entire premium if the stock ends up at or below $44, the stock would have to rise to above $45.77 for the covered call to underperform just by owning the stock. You still keep the premium if the stock ends at $44 at expiration, and the stock would have to fall to $42.73 before we would lose money on this trade.

Lastly, we will look at the in-the-money covered call, selling the $42 strike call for $3.05. Here, we are still optimistic about the stock taking a protected position that pays a moderate net income while offering a breakeven point of $3.05 below the current stock price. As long as the stock exceeds the $42 strike price, we net a $113 profit. This profit represents the time premium of the call that we just wrote (i.e., $3.05 minus the call’s tangible value of $2.00, times 100) plus the $8 dividend from the 100 shares.

Calculating the percentages

All these covered calls are reasonably attractive but offer different combinations of maximum profit, downside protection, and annual return on the premium.

Looking at the out-of-the-money $46 strike-covered call, we see that the maximum profit equals 6.79%. This is because it costs you $43.15 per share to establish the position ($44 – $0.85), and the most you can sell the stock for is $46. If the stock stands still, you get a return of 2.15% (based on paying $43.15 to establish the position and getting $44 at expiration). Multiplying this number by the 365/59, you get an annualized return of 13.31%.

Your downside protection is predicated on the fact that you paid only $43.15 to establish the position, so the stock could fall to that level before losing money. Note that all these calculations include the dividend income. With the $44 at-the-money covered call, your maximum profit of 4.37% is based on you paying $42.23 to establish the position and getting $44 at expiration as long as the stock ends up above the strike price.

If there is no change in the common, this is also your return. Your annualized return is 27.05%, and your downside protection is 4.20%. The $42 strike-in-the-money covered call with a premium of $3.05 consists of a tangible value of $2 ($44 – $42) plus the time premium and the dividend. By writing the call against your stock, you effectively have to give up your stock at the $42 strike price as long as the stock ends up above this level. Therefore, your maximum gain is $1.13. Nonetheless, this can be an attractive trade. Notice that your annualized return is 16.98% and that your cost basis is $40.95 (i.e., $44 -$3.05), which is fully 7.11% below the current stock price.

Using these calculations to manage your portfolio

The best philosophy for managing a covered call portfolio is holding good stocks and writing calls on them that offer you an attractive combination of income, protection, and profit potential. We have used realistic prices for our options calculations. An investor’s returns are handsome in markets that go sideways or trend up moderately, and they also provide a reasonable hedge in bear markets.

Writing options on hyper-growth stocks – a superior money management strategy

Writing options is especially appealing when applied with a long-term hypergrowth stock investment strategy. Why? The volatility of these stocks is high, and so are option premiums. Using the CBOE Volatility Index to define when to enter a position and choose among different money management strategies according to individual risk preferences may be the optimal investment strategy for many investors.

Historical example: Meta (Facebook) Call, Strike: 240, Expiration Date: 20 January 2023, Closing Price: 07 June 2022: 11.60 USD. Share price (closing) 07 June 2022: 195.65 USD.

Quick math: The option premium is 5.93 percent of the actual share price for a holding period of seven months which equals 10.16 percent for 12 months. This is also the downside protection in a bear market scenario. The strike price is 45 USD out of the money, so the stock may increase by more than 23 percent before it is called, and the option writer would have to sell the stock at 240 USD.

A portfolio of stocks to write options

Our selection of hypergrowth stocks on which to buy and write options is for premium subscribers only.