Are Covered Calls A Best Income Approach?
Covered calls are a popular income strategy. But, they are a risky strategy and may not be the best option for many investors.
Covered calls are a strategy that involves buying and holding a stock and selling, or writing, call options on that stock. Since each options contract covers 100 shares of a stock, this strategy requires owning at least 100 shares and using multiples of 100 shares when trading.
Writing a call is a strategy used to generate income. Selling the option generates immediate income from the stock. If the option expires worthless, the investor keeps the premium as the profit on the trade. The investor also collects any dividends since they own the stock.
Calls, like all options, have an expiration date and an exercise price. If the stock is trading above the exercise at expiration, the call will be exercised and the investor who wrote the contract will have to deliver the shares at the agreed upon exercise price.
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When a trader writes, or sells, a call, they are obligated to sell the shares if the call option is exercised.
Let’s look at an example for a notional stock called ABC which is trading at $100 per share. The investor can buy 100 shares and then write a covered call for $3, or $300 in total income. The call might expire in 30 days and have an exercise price of $110.
If the stock is trading at $100 when the option expires, the trader keeps the premium received when the option was written and keeps the stock since it is below the exercise price of the call.
If the stock is trading at $115 when the option expires, the trader keeps the premium received when the option was written but must sell the stock at $110 per share. This generates a total return of $113 per share but misses out on the $2 per share that would be earned without the covered call.
Why Investors Use Covered Calls
This strategy works best when the stock is little changed. If there is a large move, the strategy is not particularly useful. Continuing with the example above demonstrates why this is true.
Assume there is a buyout of the company and the stock price soars from $100 to $150 a share. Traders who sold a call with an exercise price of $110 will be obligated to sell at $110. In this case, they will not achieve the full benefit of owning the stock.
The stock could also decline sharply. Assume the company misses its earnings expectations and the stocks falls to $80 per share. The investor who wrote the covered call can still sell their stock. They will, however, have to consider closing the option first.
After a 20% decline, the trader who sold the call will have a loss of just 17%. The covered call will have reduced the size of the loss. It’s possible to sell the stock but the call should be closed to avoid risking exercise. This will result in extra commissions.
Investors usually consider covered calls to be useful when a stock isn’t moving much or they claim it reduces the size of a loss by a small amount. These are both true but they do not really protect against large losses and they do not allow traders to reap the rewards of large gains since they give up any gains above the option exercise price.
To understand the potential rewards and risks of a covered call strategy, a payoff diagram can be useful. This is shown below.
Source: The Options Industry Council
A Different Perspective on Covered Calls
If an investor is simply looking for a way to gain exposure to a stock they expect to remain in a trading range, rather than a covered call a bull call spread could be used. The next diagram shows the potential risks and rewards of this strategy.
Source: The Options Industry Council
Notice that the potential gains are limited, just as they were with covered calls. But, the losses are limited.
Investors will have to pay a small premium to open this position. This amount, however, will be substantially less than the cost of buying 100 shares of stock to open a covered call.
The payoff diagrams highlight the limitations of the covered call. This strategy provides two benefits. The strategy generates immediate income, which is one benefit. Second, the strategy reduces the size of a loss by a small amount if the stock declines.
But, as the first chart above shows, covered calls seem to offer the worst possible reward to risk ratio. Potential rewards are small and potential risks are large.
The bull call spread, a strategy that involves buying one call and selling a second call, offers limited risk. The upside is still limited but the risks are reduced compared to a covered call. However, the bull call spread does not meet the objective of generating income.
An Alternative Strategy
To generate income, a bull put spread could be used. The risk and reward diagram is shown below and it offers limited risk with limited potential gains.
Source: The Options Industry Council
This strategy involves two put options. One put option is bought and a second put option with the same expiration date but with a lower exercise price is sold. Selling the put generates immediate income, just like a covered call would. But, unlike a covered call, risk is limited.
This strategy meets the objective of the covered call. It generates immediate income and the shape of the curve for potential rewards are exactly the same as in the covered call diagram above.
A Specific Trade
This strategy could be applied to stocks that investors might not want to own for various reasons. For example, Golar LNG Partners LP (Nasdaq: GMLP), offers a high yield or more than 10.5%. While that yield is attractive, many analysts are concerned it is unsustainable and could be cut.
If the yield is cut, the stock price would be likely to decline sharply. This could destroy equity that is worth more than one or even two years’ worth of income. Therefore, the risks may outweigh the potential rewards. Options can avoid this problem by strictly limiting risk.
GMLP might also not be suitable for investors concerned with taxes. As a limited partnership, investors will receive extra tax forms and filing will be a more difficult process because of the stake in GMLP. Options also avoid this problem.
For GMLP, a bull put spread could be opened. This trade would be opened by selling the November 17 $22.50 put for about $1.20 and buying the November 17 $20 put for about $0.30. This trade would result in a credit of $0.90, or $90 per contract since each contract covers 100 shares.
The maximum potential gain is $90. The maximum possible risk is the difference between the exercise prices less the premium received, or $160 ($250 – $90). The potential gain is about 56% of the amount of capital risked.
The bull put spread is an example of how options are a versatile tool and could meet many of your trading objectives. In this trade, options provide income and defined risk that could be lower than owning the stock. This strategy could also simplify tax reporting for investors.
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