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Covered call writing for savvy long-term investors

Covered call writing of dividend stocks is the best strategy for conservative investors to obtain long-term above-average returns with moderate risks. You create a covered call when you buy (or own) shares of stock and write (sell) the exact amount of calls on these shares.

The premium you receive from writing the calls is your compensation for taking on the obligation of selling the stock at the strike price – the price at which the stocks can be bought – if the call gets exercised. During the time a call is not exercised dividends solely belong to the stockholder/call writer. Covered call writing is a much more flexible and dynamic strategy than most people realize. Covered call writing is also the ideal way for the typical investor to get started with options.

Introduction: Why we like covered calls

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First of all, covered call writing tends to be a relatively low maintenance strategy, partly because the individual trades have better than 50/50 odds of making a profit, and partly because the positions tend to garner income over time. Secondly, managing a covered call portfolio offers a great experience for branching out into other option trades (such as put writing, call and put buying, and spread trading).

Another feature of covered call writing that can make it attractive to the average investor is that most US brokers allow its use in Individual Retirement Accounts. Indeed, if you are interested in getting started with covered calls, your “IRA” is probably the ideal place to start, partly because you eliminate the tax consequences of profits from selling premium or of large gains on long-held stocks. In countries such as Germany, covered call writing is not yet widely used by private investors. Probably because banks like to keep that business for themselves.

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Covered calls: Doing the math

Because covered call writing involves both stock and short call positions, covered calls can be a bit more complicated than stocks alone. However, if you understand a few simple calculations, you can quickly master covered call writing and the dynamics of their management.

You create a covered call when you buy (or own) shares of stock and write calls on these shares. The premium you receive from writing the calls is your compensation for taking on the obligation of selling the stock at the strike price if the call gets exercised. Your reasons for buying (or holding) a covered call are; (1) you like the stock, and (2) at the same time, you feel that you are well compensated by the premium.

Depending on the strike price of the call, a covered call can be bullish (strike price above the stock price), neutral (strike price equal, or close to, the stock price), or defensive (strike price below the stock price).

We show three different examples of writing 59-day June covered calls on United Healthcare (UNH) with the stock at $44.00; the out-of-the-money $46 strike covered call at $0.85, the at-the-money $44 strike at $1.77, and the in-the-money $42 strike covered call at $3.05.

In all these examples, we assume that we are keeping the stock at expiration and buying the call back if it ends up in-the-money. (Letting the stock be called away at the strike price will give you essentially the same gain and loss at expiration with the main difference being that you will no longer own the stock.)

Let us look at the out-of-the-money covered call first. Here we get to keep the entire premium as long as the stock ends up below this $46 strike price. This is an excellent strategy for investors who want to be long the stock but want also want an extra income of $0.85 per share. At expiration, the stock would have to end above $46.85 (i.e., the strike plus the premium) for the stock position alone to have done better than the covered call.

Next, we look at the at-the-money covered call, a position in which we are moderately bullish on the stock, and like the income from the premium. Here we take in $1.77 or $177 on one covered call struck at $44. Although you can only earn this entire premium if the stock ends up at or below $44, the stock would have to rise to above $45.77 for the covered call to underperform just owning the stock. If the stock ends up at $44 at expiration, you still keep the premium. The stock would have to fall to $42.73 before we
would lose money on this trade.

Lastly, we will look at the in-the-money covered call, selling the $42 strike call for $3.05. Here, we are still positive enough on the stock to take a protected position which pays a moderate net income while offering a breakeven point $3.05 below the current stock price. As long as the stock ends up above the $42 strike price, we net out with a $113 profit. This profit represents the time premium of the call that we just wrote (i.e. $3.05 minus the call’s tangible value of $2.00, times 100) plus the $8 dividend from the 100 shares.

Calculating the percentages

All these covered calls are reasonably attractive but offer different combinations of maximum profit, downside protection, and annual return on the premium.

Looking at the out-of-the-money $46 strike covered call, we see that the maximum profit is equal to 6.79%. This is based on the fact that it costs you $43.15 per share to establish the position ($44 – $0.85) and the most you can sell the stock for is $46. If the stock stands still, you get a return of 2.15% (based on paying $43.15 to establish the position and getting $44 at expiration). Multiplying this number by the 365/59 and you get an annualized return of 13.31%.

Your downside protection is predicated on the fact that you paid only $43.15 to establish the position, so the stock could fall to that level before you would lose money. Note, all these calculations include the dividend income. With the $44 at-the-money covered call, your maximum profit of 4.37% is based on your having to pay $42.23 to establish the position and getting $44 at expiration as long as the stock ends up above the strike
price.

This is also your return if there is no change in the common, and your annualized return is a hefty 27.05%. Your downside protection is 4.20%. The $42 strike in-the-money covered call with a premium of $3.05 consists of a tangible value of $2 ($44 – $42) plus the time premium and the dividend. By writing the call against your stock, you effectively have
to give up your stock at the $42 strike price as long as the stock ends up above this level. Therefore, your maximum gain is $1.13. Nonetheless, this can be an attractive trade. Notice that your annualized return is 16.98% and that your cost basis is $40.95 (i.e. $44 -$3.05), which is fully 7.11% below the current stock price.

Using these calculations to manage your portfolio

The best philosophy for managing a covered call portfolio is to hold good stocks and to write calls on them that offer you an attractive combination of income, protection, and profit potential.

We have used realistic prices for our options calculations. The returns you can obtain are very attractive in markets that go sideways or trend up moderately. They also provide a reasonable hedge in bear markets.

 


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