A Cabot Primer: How to Write Covered Calls
05/02/2017 2:45 am EST
Writing covered calls is a great way to boost your yield on stocks you already own, and involves a lot less risk than most investors think, explains dividend expert Chloe Lutts Jensen, editor of Cabot Dividend Investor.
A call option gives the owner the right to buy a stock at a certain price (the strike price). When you sell call options on stocks you own, you’re selling some other investor (your counterparty) the right to buy that stock from you in the future, if the price hits your strike price.
For example, let’s say I own Coca-Cola (KO), which is currently trading around 43. If I sell a KO call option that expires in June and has a strike price of 45, one of two things could happen:
Option 1: KO stays below 45 until the call expires in June. I get to keep my KO stock, and the amount I sold the call for (which is called premium).
Option 2: KO rises above 45 before my call expires. The person who bought the call from me exercises the call, buying the stock from me for $45 per share. I get the money from the sale and the call premium, but I don’t own the stock any more.
How to Write Covered Calls
To write a covered call, choose a stock you already own and for which there is an options market. Decide how many calls you would like to write (writing means selling). Each call gives the owner the right to buy 100 shares of that stock, so if you own 200 shares of Coca-Cola (KO), you can write two calls.
Since the option will only get exercised if the stock rises, the best stocks to use (assuming you want to keep them) are stocks that you don’t think will go up right away. Stocks in sideways trends are good candidates.
Next, pick a strike price and when you would like the calls to expire. If you sell calls expiring soon, there’s less risk that your stock will rise above the strike price and get called away. But if you sell longer-dated calls (calls that don’t expire for a few months), you’ll get paid more.
Same with the strike price: If you sell calls at a strike price closer to the current price, you’ll get paid more, but there’s also a greater chance that your stock will hit that price and get called away. It’s a risk vs. reward tradeoff.
Now, find out what someone will pay for those calls. As of this writing, the market is paying 53 cents for September 45 KO calls. That means you can sell someone the right to buy your KO stock at 45 until mid- September, and they’ll pay you 53 cents per share for that right.
If that seems too risky—if you think it’s pretty likely that KO will hit 45 by September—you can sell shorter-dated calls or calls with a higher strike price. But you won’t get paid as much.
The market will pay 19 cents for June 45 calls, which might be acceptable to you. Or you can raise your strike price too, but your premium dwindles even more—for June 50 calls, you’ll only get three cents. The market thinks it’s pretty unlikely that KO will move to 50 by mid-June, so taking on that risk doesn’t earn you much.
How to Profit From Covered Calls
Let’s say we write the September 45 KO call for a premium of 53 cents. For each contract, we collect $53 when we sell the call. So now we have 100 shares of KO, $53 in cash, and the obligation to sell our shares for $45 each if they get there before September. Here’s what could happen next:
Scenario 1: Desired Outcome
If KO stays below 45 until the calls expire in September, the calls expire worthless. We get to keep our stock plus the $53 we made by selling the call. Nice!
Scenario 2: But Stocks Can Go Down …
As long as KO stays below 45 for the next five months, our call will expire worthless and we’ll get to keep the $53 premium. But what if the stock doesn’t stay just below 45, it goes down? We’ll have to absorb the losses from the stock’s decline, and it will gradually eat into our profit. If KO falls to 42.47, our call premium will be erased, and we’ll essentially have broken even.
And if KO continues to fall, we’ll get further into the hole—and may want to consider selling the stock and closing our call position.
Scenario 3: No Stock, But Money!
Lastly, if KO rises above 45 before our calls expire in September, the owner of the call will exercise his right to buy our shares for $45 each.
We’ll have to sell our stock for $45 per share, regardless of where KO is trading at expiration. If KO has gone up a lot, we’ll miss out on some upside—rats. But we’ll earn $253: our call premium, plus the $2 per share appreciation in KO.
Selling covered calls is particularly popular among income investors because you can generate high yields in a short amount of time. If our KO trade works perfectly, we earn 53 cents per $43 share, effectively generating a 1.2% yield in five months.
Our maximum profit is capped at $253, but we’re not taking on any additional risk by selling the calls (other than the risk of KO going down that we were already exposed to, and in fact, we’ve mitigated some of that).