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Covered Calls Primer | Money For Nothing


Published on December 11th, 2020 by Dirk Leach

This article is a guest contribution from Dirk Leach.

Writing covered calls is not quite “Money for nothing”, but it is as close to free money as I’ve been able to find.  I spend roughly an hour every other week looking for possible covered call opportunities, reviewing my existing covered call positions, and/or rolling those positions at risk of getting exercised.

For that little bit of effort, I’ve collected well more than $25k in call option premiums YTD in 2020.  This article explains what covered calls are, how you find good covered call opportunities, and how to actually write (sell) covered calls. I’ll also cover the risks of writing covered calls (miniscule) and how to roll up and out a covered call at risk of being exercised.

Finally, I’ll provide some specific examples of stocks that are good candidates for writing covered calls versus stocks that are not as good a candidate.

Covered Calls

A covered call option is a financial transaction in which the writer (seller) of the call option receives a premium (cost of the option) in return for granting the call option buyer the right to buy the specified number of shares from the investor at the agreed upon strike price for a period of time determined by the option expiration date.

The buyer of the covered call has the right (not obligation) to purchase the underlying shares from the investor at the option strike price anytime up through the option expiration date. The investor’s long position in the asset is the “cover” because it ensures the call writer (seller) can deliver the shares if the buyer of the call option chooses to exercise the option.

Stock options are traded as “contracts” because the transaction is truly a contract between an option seller and an option buyer regarding the option to purchase shares owned by the option seller at a specified price for a specified period of time. One “contract” represents 100 shares of stock. For example, if you owned 500 shares of AT&T (T), you could sell a call option for a minimum of one contract (100 shares) up to a maximum of 5 contracts (500 shares).

AT&T has long been a favorite stock for income investors, as it has raised its dividend for over 30 years in a row. AT&T is a member of the Dividend Aristocrats, a group of 65 stocks in the S&P 500 Index with 25+ consecutive years of dividend raises. You can see all 65 Dividend Aristocrats here.

AT&T is also a useful example for writing covered calls to further increase income.

There are six exchanges in the US that trade stock options with the largest being the Chicago Board Options Exchange (CBOE) clearing roughly one third of all options traded in the US. The Options Clearing Corporation issues options traded on the floor of the CBOE and also clears the CBOE transactions. The existence of the Options Clearing Corporation ensures that buyers and sellers of options remain anonymous.

Where Do You Find Listed Stock Options?

Stock options tables or listings can be found on dozens of websites. The one I like best is found on the Financials page of Yahoo.com. Look up a stock using the search bar at the top, look just below the current stock price for the line of blue links, and near the right side you will find the options link. A snip is provided below.

Source:  Yahoo.com

Once you get to the options table, you will need to pick an expiration date for the call option in which you are interested. For this example, we’ll stick with T and choose the April 16, 2021 table from the drop down menu. The table will have changed since this article was published but you will see something similar to the one below.

Source:  Yahoo.com

Across the top of the table above you see the following headings.

Selecting A Call Option To Write (Sell)

When searching for covered call candidates, I typically try to find options that will provide a 10% or greater annualized return based on the option price (premium) versus the current price of the underlying stock. I also try to select options with a strike price at least 10% above the current price of the underlying stock. You can’t always get both of those constraints satisfied because, as you go up in option strike price, the price (premium) for the option goes down. Also, stocks with low volatility (daily price fluctuation), like T, often do not have options prices that meet the 10%/10% criteria.

If we use the T April 16, 2021 options table above, we can work out an example to see if we can get to the 10%/10% criteria. With the stock price for T currently about $29, 10% above that price is roughly $32. At a strike price of $32, the April 16, 2021 option price (premium) is about $0.40.  and roughly 135 days out. So, the annualized premium is ($0.40/$29) x (365/135) = 0.037 or 3.7%

Nowhere near my desired 10%. Does this mean T is not a good covered call options candidate. No but it does mean that I’d have to accept a lower annualized return, a lower strike price, or some combination of those two. I’ve made good money on T options buy accepting a lower strike price closer to the current stock price and accepting less than a 10% annualized return. This works because T is a low volatility stock and the risk of T shooting up past the strike price (deep in the money) is pretty small.

For another example, we can look at Diamondback Energy (FANG), a mid-sized oil exploration and production firm with significantly more volatility in its stock price. Below is the March 19, 2021 call options table for FANG.

Source:  Yahoo.com

FANG is priced at about $42 per share today and is up over 5% as I write this. As a consequence, we can see the call options pricing is also moving up and by a lot more than 5%. Options price (premium) volatility is typically several times higher than the stock price volatility. Options are typically short duration contracts and the options price is sensitive to the relative change in stock price between the current price and the strike price.

Using the FANG call options table above, we can repeat the same 10%/10% test we did for T. Because FANG is not nearly the size of T and FANG options are not traded as heavily, FANG options pricing is in increments of $5 versus increments of $1 for T. The closest we are going to get to a strike price 10% above $42 is at $45. At $45, the March 19, 2021 call option is price between $5.00 and $5.30 so I’ll typically use the average of the bid and ask pricing. The annualized return is roughly ($5.15/$42) x (365/107) = 0.42 or 42%.

Even if we move up to a strike price of $50, the annualized return is about 31%.

Risks Inherent in Writing Covered Calls

The short answer is that there really is no risk. If you write your call options at a strike price above the current stock price and the call gets exercised (because the stock price rose above the strike price), the worst that can happen is your shares get called away at that strike price and you keep as compensation the covered call premium. That’s it. It is impossible to lose money on covered calls provided you write (sell) those calls at a strike price above the current stock price.

What happens if the stock price blows past the strike price but I really don’t want the shares of the stock I’ve pledged to be called away; I don’t want to sell the shares? The simplest approach would be to buy back the “in the money” call option. However, being “in the money” often means “buying to close” the call option will be an expensive choice.

The strategy I use is referred to as rolling an “in the money” call option “up and out”. In the nearly 7 years I’ve been writing covered calls, I’ve had exactly one stock called away. This was shortly after I started writing covered calls and I did not yet fully understand how to roll an option. I roll call options “up and out” pretty frequently now; on the order of 12 to 15 times a year to prevent a stock I wish to retain from being called away.

Rolling an option “up and out” takes advantage of the time value of options. The figure below shows a generic time value decay curve for a standard call option.

Source: The Options Prophet

The price (premium) of a near term option (e.g. a month from expiration/exercise) is lower compared to the same option strike price 3-4 months further out. This is because with a longer duration to the expiration/exercise date, the probability of the stock price exceeding the strike price is higher; sometimes significantly so. By executing a simultaneous “buy to close” on the “in the money” option with a “sell to open” on a longer dated option, you can often pick up enough time value to also raise the strike price up another increment or two. Rolling “up and out” works well with options that are liquid with close pricing increments (e.g. $1.00) and is harder to accomplish with a stock whose options are less liquid and often priced in increments of $5. It is a lot easier to jump to a higher strike price increment of $1.00 than do so with an increment of $5.

Other Covered Call Considerations

Below is a list of other considerations that an options writer should understand and apply when researching what calls to write.

Conclusion

Writing (selling) covered calls is a relatively simple options strategy that has essentially no risk other than potentially having the underlying stock called away. Even that can typically be prevented by rolling the option up and out prior to the option expiration/exercise date. Because there is essentially no risk in writing covered calls and because it takes so little time to research and execute options trades, many equity investors could benefit by writing covered calls to bolster the returns on their equity holdings.

And if you are looking for covered call trade ideas, take a look at the video below.

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