Covered calls are the most common strategy for trading options, an easy low-risk way to boost income in a stock portfolio.
And advocates say today’s conditions are favorable, with stocks moving sideways and many investors trying to earn more than they can with more mainstream income-producing investments — 10 or 12 percent a year, or more, if things go well, according to some experts.
“Investors who believe that their investment is unlikely to deliver robust gains can sell covered calls to exchange the uncertain upside for modest current income today,” says S. Michael Sury, an investing and finance lecturer at the University of Texas at Austin. “For investors that believe that the market has topped out, this may be a way to incrementally boost portfolio yield.”
[See: 10 Long-Term Investing Strategies That Work.]
Covered calls are suitable for older investors seeking income, not young people investing for growth, says Robert R. Johnson, principal at the FedPolicy Investment Research Group in Charlottesville, Virginia, and former president of the American College of Financial Services.
“It tends to work best when the investor expects short-term price weakness due to company-specific factors, or industry or sector or even overall factors, but has a generally optimistic forecast in the longer term,” Johnson says.
Options are contracts that give the owner the right to buy or sell a 100-share block of stock at a set “strike” price any time over a period of days to years. A “call” gives the option owner the right to buy, a “put” the right to sell. In exchange for a payment called a “premium,” the seller, or “writer” of the call contract promises to deliver the shares if the buyer chooses to exercise the right to buy.
The writer earns the premium and sells at a price he or she found acceptable when the contract was written. Of course, that means missing any gains above the strike price, so it’s a good strategy only if selling is desirable — to lock in past gains, for example — or if the writer does not expect the price to go up.
For example, last week, Apple (ticker: AAPL) was trading at $186.24. A call option allowing its owner to buy at $195 a share through Aug. 10 could be purchased for $3.36 a share. An investor who owned 100 Apple shares could therefore have earned $336 for writing this contract, earning 1.8 percent on shares worth $18,624. An investor who did this month after month could earn a significant income.
The writer can still suffer a loss, Johnson notes.
“The investor still owns the stock, which can experience a decline,” he says. “But, the investor retains the premium of the written call to slightly mitigate such a loss. The most significant potential loss could be the opportunity lost if the market price of the stock rises sharply.”
The call owner will generally exercise only when the share price has gone up, allowing the buyer to acquire the shares at the lower strike price in the contract and immediately sell them for more, or to keep them in hopes of further gains. If the price has fallen, the option owner will not exercise and the seller will keep the shares and the premium.
Selling a “covered” call means the contract writer already owns the shares promised. With a “naked” call, the writer does not own the shares and must acquire them if the option owner exercises, producing a theoretically unlimited loss if the shares skyrocket and must be bought high and sold low. So writing naked calls is only for risk-loving speculators.
For the covered call writer, the ideal situation is when the shares do not go up before the option expires and the writer keeps them and the premium. After the option expires the writer can write another, and some investors play this game constantly.
[Read: 4 Tips to Dodge Summer’s Portfolio Blues.]
Many experts say today’s conditions are favorable for writing calls. The broad market is flat for the year, so if your stock isn’t going up, why not make a little extra cash while you wait for things to improve? Also, the premium earnings will soften the loss if the shares fall.
While 401(k) plans generally do not provide for options trading, it is possible to write covered calls in traditional IRAs, Roth IRAs and rollover IRAs funded from 401(k)s.
“An advantage in writing covered calls in an IRA or 401k rollover is that the income from selling the options isn’t taxable until funds are withdrawn from the account,” Johnson says. “If you write a covered call in a regular account the option premium is taxable” as income. Gains in Roth IRAs are tax free.
Calls can be written on exchange-traded funds, real estate investment trusts and some other types of funds, but not open-ended mutual funds. To write calls you need an options account with your broker.
“Options are a complex investment,” says Eric Kovalak, president of Entramarket Capital Management, an option trading hedge fund based in Grand Rapids, Michigan. “Investors using covered call strategies should understand the formulas for how options are priced, and also take time to learn the correct way to execute an option order in the market.”
The CBOE options exchange and many brokers, offer options trading tutorials
Among things to consider:
What is the stock’s prospects? In writing a covered call, the investor bets on whether the stock will go up, down or sideways, just like betting on the stock itself. Experts also recommend starting small and writing calls only on stocks or funds that are actively traded in the options markets, to be sure of having a buyer for the contract.
“One of the biggest drawbacks is that it can impart a high degree of regret risk,” Sury says. “If an investment continues to rise beyond the strike price of the strategy, the investor forgoes all that appreciation. Moreover, writing covered calls does not protect an investor against an investment that continues to depreciate.”
Is it in, at or out of the money? Call writers can choose the strike price to be used in the contract. An “in the money” call allows the owner to buy shares for less than the market price when the contract is written, offering the potential for an immediate profit. The writer comes out ahead if the shares fall.
Alternatively, the writer can sell an “out of the money” contract with a strike price higher than the current share price. The premium will be smaller since the contract may expire worthless if the share price does not rise enough to cover the premium expense and provide some profit as well. The writer can come out ahead if the shares fall, remain flat or rise just a little, but not enough to induce the options owner to exercise.
[See: 7 Things You Need to Understand About Your 401(k).]
“The ideal scenario for a covered call writer is to sell covered calls that are out of the money and have the stock slowly rise so that the investor retains the stock and can sell another covered call at hopefully a higher strike price when the option expires,” Johnson says.
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Covered Calls Are Attractive in a Flat Market originally appeared on usnews.com
