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Strategy Focus: The Truth About Covered Calls

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January 1, 2014
option trading truths about covered calls
Fredrik Broden

From newbie traders to retirees, covered calls are becoming an important strategy to consider for both margin and IRA accounts. And because they’re so popular, you probably think you’ve got it nailed down—i.e., buy 100 shares of stock then sell a call. Sounds simple, but is there more? In thinkMoney fashion, we’ll explore a different way to think about covered calls.

Covered Calls 101

First, let’s nail down a definition. A covered call is a bullish strategy that’s always long stock, and short an at-the-money or out-of-the-money (OTM) call, where you have 100 shares of stock for every call you sell short. That’s the case for the majority of equity options in the U.S. that deliver 100 shares of stock. On the other hand, if you sell, say, 2 calls against 100 shares of stock, that’s a different strategy, not a covered call, and that extra short call would be “uncovered.”

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FIGURE 1: COVERED CALL PROFIT CURVE. The covered call can limit your upside, but the additional premium you collect will lower your cost basis and can increase the duration of the trade. For illustrative purposes only.

To create a covered call, you short an OTM call against stock you’ve bought or already own. If it expires OTM, you keep the stock and maybe sell another call in the next expiration.You can keep doing this expiration after expiration, unless the stock moves above the call’s strike price. In that case, you can either let the now in-the-money (ITM) call be assigned and deliver the long shares (that’s why the short call is considered “covered”), or you can buy back the short ITM call before expiration, take a loss on that call, and keep the stock. Check out the Strategy Roller on thinkorswim. It lets you automate the rolling process based on time, strike, delta, and expiration.

Now, For Traders...

Traditionally, the covered-call strategy has been used to pursue two goals:

1) Generate income
2) Act as a hedge against a stock price’s drop

And while those two things may occur, they’re not the primary reasons a savvy investor might use covered calls. For starters, generated income implies consistency—something in fact the market can’t promise. In theory, income from a covered call comes from your credit when you sell the call (minus commissions). But the price for which you can sell an OTM call is not necessarily the same from one expiration to the next, mainly because of changes in implied volatility. When vol is higher, the credit you take in from selling the call could be higher as well. But when vol is lower, the credit for the call could be lower, as is potential income from that covered call. That’s why if you’re using the covered-call strategy to pay bills, you might want a backup plan.

A covered call can act as a hedge for long stock if the stock price drops, the short call expires OTM, and the short call’s profit offsets the long stock’s loss. But if the stock drops more than the call price—often only a fraction of the stock price—the covered-call strategy can begin to lose money. In fact, the covered call’s maximum possible loss is the price at which you buy the stock, minus credit(s) from short calls. The bottom line? If the stock price tanks, the short call potentially offers minimal protection at best.

Okay. So what’s the lure for traders?

Lower cost basis. In a covered-call strategy, the stock’s cost basis is the price you paid for the stock, minus your credits from covered calls. If you buy stock for $50, and sell an OTM call for $1.00, your stock’s cost basis is $49. If that first OTM call expires worthless and you sell another call for $.75, the stock’s cost basis goes down to $48.25.

Now, this definition of cost basis has nothing to do with tax reporting. Consult your tax expert for that. This particular definition is how a trader might see it. And that’s important. Because theoretically, if the current stock price is greater than your long stock’s cost basis, the position should be profitable. The lower your cost basis, the lower the stock price has to be for it to be higher than the cost basis. Imagine the scenario if your stock’s cost basis is $0. (That might sound unlikely but it can happen in certain stock-compensation plans.) Because the stock price can’t go below $0, as long as it’s $.01 or higher, that position can be profitable. So think of covered calls as pushing a long stock’s cost basis lower and lower. Maybe not to $0. But potentially lower than the stock’s current price.

The advantage of a lower cost basis comes down to the likelihood of the long stock position being profitable. If you bought 100 shares of ABC at $50, and another 100 shares of ABC at $51, which 100 shares would have a better chance of being profitable? The shares you bought for $50 only have to be above $50 to be profitable, while the shares you bought for $51 have to be above $51. Think of cost basis as the long stock’s breakeven point. The lower the breakeven point, the less the stock has to go up in order to be profitable. And the less the stock has to go up, the higher the likelihood of it making that move. A 1% move is more likely than a 10% move.

Longer duration. Covered calls can also increase the duration of how long you might hold a long stock position by hedging against losses. Reducing the cost basis by selling calls against the stock means you can move the price of a stop loss lower (either a mental stop or stop order).

If you wanted to stop the loss of 100 shares of stock at $300, the stop price would be $48 for 100 shares, with a cost basis of $51, and $47 for 100 shares, with a cost basis of $50. If the current stock price is $50.50, there is a greater chance it would hit a $48 stop than a $47 stop. That extra downside room means you might hold that stock position longer and give it more of an opportunity to rally.

Taxes Schmaxes

Some people are concerned their stock will be called away with a covered call and trigger a taxable event. The logic is that if the stock gets called away, the price has moved up higher than the strike price of the short call, and is either profitable or has a smaller loss.

For long-term investors, this may not be desirable. But from a trading perspective, this is a good thing. Profit is profit. And that’s the name of the game. A long-term investment means you’re speculating that the particular stock will outperform, which may or may not happen. When viewing covered calls as a trading strategy, not an investing strategy, the goal becomes whittling down the cost basis, while increasing the probability of profit and duration—things over which you have a lot more control. The process over time should become almost mechanical, which could grow your confidence in your trading decisions. That’s good for newbies, retirees, and even traders like you and me.

The information presented is for informational and educational purposes only. Content presented is not an investment recommendation or advice and should not be relied upon in making the decision to buy or sell a security or pursue a particular investment strategy.

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