How to obtain +20 % annual revenue with moderate risks. Covered call writing for savvy short and long-term investors

KEY POINTS

• Covered call writing of dividend aristocrat 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 on high beta tech stocks may yield revenues exceeding 20 % annually, providing both - a cushion for stock market declines and leaving room for stock appreciation.

Introduction: Why I 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 want to get 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 significant gains on long-held stocks.

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.)

Out-of-the-money covered calls

Let us look at the out-of-the-money covered call first. We can keep the entire premium if the stock is below this $46 strike price. This is an excellent strategy for investors wanting to own the stock but wanting an extra $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.

At-the-money covered calls

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 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.

In-the-money covered calls

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 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 you paying 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 paying $42.23 to establish the position and getting $44 at expiration as long as the stock exceeds 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 your cost basis is $40.95 (i.e., $44 -$3.05), which is 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

When applied to a long-term hypergrowth stock investment strategy, writing options are especially appealing. 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.

Historical example: Shoals (SHLS) Call, Share price 16 October 2023, 16.13 USD, Call Option: Strike 17.5 USD, Expiration Date 17 November 2023, Option premium 1,00 USD. The option premium is 6.2 %. The strike price is 8.48% out of the money, the maximum share price appreciation an investor can keep until the expiration date, which is a month away.

A few things may happen now: SHLS does close below 17.50 USD on the expiration date (17th November 2023). The "call writer" can keep the shares and the option premium. 6.2 % for a holding period of one month is an annualized return north of 72 %. SHLS may rise to 20 USD upon expiration day. The "call writer" has to sell the shares to the options buyer for 17.5 USD. She purchased the shares for 16.13 USD and received the option premium of 1.0 USD. This is as if she would have sold the shares for 18.5 USD, a profit of 2.37 USD for a holding period of 1 month (quite okay, but still, the shares were at 20 USD on expiration day!). Shoals may crater and close at 12.50 USD on the expiration date. The call writer would reduce the loss from the share purchase by 1 USD but would not be fully covered if the stock moves vertically south (crashes).

After the calls have expired (probably one would do that much earlier because it does not make sense to wait until the expiration date, but instead would buy back the option for a small amount much earlier and sell another option immediately, applying the "Greeks" - maybe selecting the expiration date January 2024 for another Dollar or so), she sells options again.

She continues the exercise for a year as the stock will not rise above 17.5 USD and will be able to collect between 8 - 10 USD in option premiums (depending on how she selected the strike price and the duration of the calls).

How to fine-tune the option selling strategy depends on one's perception of the future price action. There can be a focus on price appreciation of the stock and modest option premiums. There can be a focus on maximum option premiums and little share price appreciation. There can also be a focus on the max hedge in a bear market (selling deep in the money calls).

A portfolio of stocks to write options

Our selection of high-beta hypergrowth stocks to buy and write options is for premium subscribers only. They offer both - share price appreciation appeal and high option premiums. Please DM me for further insights.