The covered call is one of the most widely-used portfolio diversification tools, but it’s important to understand how it works.
The covered call is one of the most straightforward and widely used options-based strategies for investors aiming to diversify portfolios and enhance returns. Still, that doesn’t mean that just any dumb cluck should try it. It’s important to understand how this tool works.
How to explain the covered call? Let’s return to some familiar imagery: You already own the eggs in your basket. But what happens if one of those eggs tumbles to the ground and cracks? Fortunately, you were thinking ahead and struck a deal with Farmer Brown (who also happens to be an options trader). That agreement, in exchange for an up-front fee, compensates you if one of those eggs drops in value (breaks). But guess what? Even if the actual egg’s price goes up, it’s no big deal—because you’re only out the fee you paid Farmer Brown, and you can hold onto your precious eggs as long as you want.
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As with the “married” (aka protective) put, the basic idea behind the covered call is to help insulate against potential losses in stock you already own. Except in this case, you’re selling the call, meaning you may be obligated to sell your stock at the strike price to whoever purchases the call. But take note: an option contract, even if you sell it, is still an asset that can accrue value, and it can effectively reduce your threshold for turning a profit on the underlying stock if all goes well. A different twist, yet it’s still aimed at protecting your equity holdings.
“Covered calls are good for at least two reasons,” said Joseph Burgoyne, a director with the Options Industry Council, a Chicago-based trade association that provides research and education programs. “First, for income generation; and second, to lower the break-even point on the underlying stock.”
Let’s look at a simple example.
Say you own 100 shares of XYZ Corp., which is trading at $50. In the options arena, we find several strike prices for each expiration month (see figure 1). For now, let’s look at calls that are “out of the money”—which means strike prices are higher than the current price of the underlying stock. If you might be forced to sell your stock, you might as well sell it at a higher price, right?
FIGURE 1: COVER ME. For the stock in this example, call option strike prices (yellow circles) are available in 50-cent increments. Source: TD Ameritrade. For illustrative purposes only.
As long as the stock remains below the strike price through expiration, then the option will likely expire worthless. Options are subject to “time decay,” meaning they will decrease in value in the days and weeks to come (all other factors being equal). As the option seller, this is working in your favor.
You might consider selling a 55 strike call (one option contract typically specifies 100 shares of the underlying stock). You run the “risk” of having to sell your stock $5 higher than the current price, so you should be comfortable with that prospect before entering the trade. But you’ll immediately collect $1 per share ($100) less transaction costs. That’s in addition to whatever the stock may return during this time frame.
FIGURE 2: OPTIONS STRATEGY MENU. The covered call (yellow arrow), along with other option combinations, can be found by clicking on Select Strategy under the Options Chain tab. Source: TD Ameritrade. For illustrative purposes only.
Many investors use this approach, even in individual retirement accounts, in addition to any dividend collection strategy as part of a monthly income generation plan.
You might be giving up the potential for hitting a home run if XYZ rockets above the strike price, so covered calls may not be appropriate if you think your stock is going to shoot the moon. But in markets that are moving more incrementally, this strategy can be beneficial. Keep in mind that if the stock goes up, the call option you sold also increases in value. Since you’re short the call, that position is now going against you, but that’s part of the risk you run with an options-based diversification strategy.
Still, two things are working in your favor. First, if the stock price goes up, the profit from your stock will most likely outweigh the option loss, thus netting you an overall profit. Second, the option losses may be only temporary as time decay sets in. The best of both worlds is if the stock price moves up near the strike price at expiration. At this point, profits come from both the increase in the share price, as well as from keeping the full premium of the now-worthless option.
A covered call has some limits for equity investors because the profits from the call are capped at the sale price of the option. You can’t make any more profit from the option once it goes to zero. So, in markets moving aggressively lower, the premium collected from the covered call likely won’t be enough to fully offset the loss of the stock (this is where paying the upfront cost for a short-term hedge to a stock or portfolio with put options might come into play).
Investors have more tools than ever at their fingertips to implement option strategies designed for hedging risks and maintaining diverse portfolios. There remains a perception that options are risky, Burgoyne noted, as some lump the instruments in with other types of derivatives. And it’s true. They do carry unique and often significant risks. But that’s not entirely fair. “These are wonderful tools if used in the correct manner,” he said.
With married puts and covered calls now in the mix for your consideration, we’ll look next time at combining these ideas to create a stock “collar” that is designed to hedge a portfolio without the higher cost of a put alone.