Stock options have a tough time trying to convince investors that they can be used to lower your portfolio risk. They are typically categorized as a high risk investment. But this is not always the case. The following talks about one way that we can use stock options to mitigate losses if stock prices fall. It is a strategy known as covered call writing and can help protect your portfolio while also generating some income. Here you go:
Writing covered calls is the strategy of writing (selling) call option contracts while at the same time owning an equivalent number of shares of the underlying stock. It is probably the most basic and most widely used option strategy by individual investors. Here’s how it works:
The option buyer pays you, the covered call writer, a premium for the right, not the obligation, to buy your shares or exercise the option on or before the expiration date, which is usually the third Friday of the month that the option expires.
When you think about it, covered call investing isn’t much different than simply buying and selling stocks, which most people are already doing and are already familiar with. The difference is when you write covered calls on stock that you already own, you agree to sell your stock at a specific price known as the strike price. The covered call that you sell generates income for you via an option premium that you pocket immediately (actually, it is deposited into your brokerage account the following day). This ability to generate income, over and above any dividends paid out by the stock that you own, is the key and the strength of covered call investing.
Now let’s look at a scenario where a covered call would be considered:
You just bought 500 shares of XYZ stock at $10 in May for a total investment of $5,000. You consider it a long term holding (hold for at least five years) but you do not expect the stock to significantly increase in value over the next two years. You can generate income from this stock by selling 5 XYZ call options with a strike price of $15 that expire in June. If the price of the option is $1.00 per contract, then the premium that you would receive is calculated as follows:
5 contracts x 100 shares per contract x $1.00 per contract = $500
As long as the XYZ stock price does not go above the $15 strike price before expiration date in June, you will keep the stock and pocket the $500 premium. This equates to a 10% return (120% annualized) on your original investment of $5,000. Additionally, you can now write another 5 covered calls on the same XYZ stock.
However, if the stock price rises above the $15 strike price at anytime before the expiration date in June, the call options can be assigned and you will have to sell your 500 shares of XYZ stock at $15 per share. This time, your profit would be calculated as follows:
$500 premium + $2,500 ($5 gain per share x 500 shares) = $3,000.
This equates to a 60% return on your original investment of $5,000. Now, you can take that $8,000 to buy XYZ stock again and write some more covered calls.
Here are the characteristics of the covered call strategy. Knowing these will help you make the best decisions on implementing your covered call program.
Best Time to Use
- Though the covered call can be utilized in any market condition, it is best employed when you meet the following criteria:
- Bullish on the underlying stock.
- Feel that its price will not fluctuate substantially over the lifetime of the call contract.
- Desire to generate additional income (over dividends) from shares of the underlying stock.
- Want to provide a limited amount of protection against a decline in the underlying stock price.
Advantages
- Generates income because you keep the premium received from writing the call regardless of what happens to the underlying stock.
- Offers some protection from a decline in price of the underlying stock.
- Lowers the overall risk of your portfolio.
Disadvantages
- Places a ceiling on any additional gains in the underlying stock price.
- Downside protection is limited (but still less risky than owning the stock without any covered calls).
This strategy doesn’t fully protect your stock investments if prices fall but it lessens the blow by providing income. Option strategies can be very confusing, especially if you are not using them every day, so if you have any questions, please feel free to contact me.
Joe Baker, CFP®
Baker Asset Management, LLC
joebaker@bakerassetmanagement.com
