In the last post I discussed the generation of income from a portfolio through the regular sale of stocks and the capture of capital gains. This is a way when traditional income investments, like bonds and utility stocks, aren’t paying significant dividends because interest rates are low. A second way to generate income when dividends are low is to use options called calls in a strategy known as covered call writing. This is definitely a strategy worth knowing and is fairly low risk, but I have had mixed results. Here I’ll present some background, discuss the risks, the provide an example and some lessons I’ve learned in practice.
Covered Call Writing – Some Background
Covered call writing is a way to create a flow of income even if a stock does not pay a dividend, reduce risk, and even do better than investing for capital gains in flat markets. In writing a covered call, an investor who owns shares of a stock (the call writer)writes a legal contract to another individual (the call buyer) which gives the second individual the option (but not the obligation) to buy the shares for a predetermined price. In exchange for the right to buy the shares, the buyer pays the writer a fixed amount called a premium. Just like a coupon, the offer is only good for a limited amount of time and expires on a specified date. After that date, the contract is null and void and the option writer is free to hold onto the shares or write and sell another contract. The writer also keeps the premium.
To simplify the pairing of option writers and option buyers, an exchange – the Chicago Board Option Exchange (CBOE) – was created. The CBOE set up standard expiration dates and creates an “orderly market,” which means that there are regulations on how option buyers and writers are brought together and standardization in the terms of the contracts. For example, all options for a month expire on a specified Friday (actually Saturday morning, but trading stops after Friday night) each month. This arrangement with the CBOE also frees the option writer from needing to actually write a contract. Writing an option is as simple as calling your broker or pressing a few buttons online.
There are specified intervals for the selling price, called the “strike price.” In general strike prices are set at $5 increments, except for lower priced stocks that can be set at $2.50 increments. The expiration month for options can be written for several months out (about 6 months). There are also longer term options called LEAPS that can last for several years.
In writing an option, an investor calls his broker with the name of the stock, the expiration month, and the strike price. For example, a holder of 1000 shares of Apple might contact a broker with an order to write 10 Apple July $100 calls (a call option is the right to purchase shares at a specified price, a put option is the right to sell shares at a specified price). This would give the buyer the right to purchase the shares 1000 of Apple at any time between today and July for $100 per share. Note that each call gives the right to buy 100 shares. In exchange for this, the writer might collect $200 per call, or $2000 total.
The price received, called the premium, is based on three factors. 1) the price of the stock, 2) the time until expiration, and 3) the level of volatility in the price of the stock. Let’s go through each of those factors:
1) The Price of the Stock.
The first factor affecting the price of options is the price of the stock on which the option was written. Obviously, if Apple stock was trading at $110 the day the option was written, the buyer would be willing to pay at least $1000 per option, since he could exercise the option, pay $10,000 per 100 shares, and turn around and sell the shares for $11,000. If the price of the stock is above the strike price, the option is said to be “in-the-money” and will sell for the difference between the share price and the strike price plus a little more.
An option below the strike price will still have a value (due to the other two factors to be described). Such an option is said to be “out-of-the-money.” Obviously, an “out-of-the-money” option is less likely to be worth anything before it expires (like having a coupon to buy shoes for $100 each when they are on sale for $90), and therefore the premium collected from their sale will be less than that for in-the-money calls.
2) The time until expiration.
Options that are good for a long time are worth more than those about to expire. Thinking about a coupon that gave you the right to buy a pair of shoes for a certain price, a coupon that gave you the right to buy shoes at $100 per pair for three years would be worth more than one that expires in a month, particularly if shoes are currently selling for $90 per pair now but they might sell for more in the future. (This is actually the main reason options were invented – to allow people who need a product in the future, like wheat, to lock in a price rather than take a chance of not being able to afford the item later.)
In general the amount of the price of an option that is due to the time until expiration stays about constant until about 90 days out, then begins to decay rapidly. This means that when writing calls it is worth it to sell calls that expire 2-3 months out because you’ll get a lot more per call than if you sell one that expires in 20 days, but it is not worth it to sell them for 6-months out because you won’t get that much more for the extra three months and you run a greater risk of the stock price ending above the strike price or the shares falling in price before the expiration.
3) The volatility of the stock price.
The volatility of the stock price affects the price of the options since a stock that moves quickly with large fluctuations in price is more likely to close above the strike price than one that does not. In our shoe example, if the price of shoes is going between $90 and $120 per pair from week-to-week, your coupon that allows you to buy them at $100 would be worth more since that might be a bargain when you wanted to actually buy the shoes. If shoes had sold for around $90 per pair for years with little change, it is unlikely that $100 per pair would be a good price unless there was a sudden run-up in shoes.
Now that I’ve laid out the basics of covered call writing and some of the factors affecting their price, I’ll present some rules-of-thumb and strategic considerations:
1) When looking to write covered calls, one must pick a stock that is relatively volatile and therefore has relatively high option premiums. In general, unless you can get an annual return of about 20-30% from the premiums, option writing isn’t worth doing. For example, if you could sell the 10 Apple 100 calls for $2500 every three months, or $10,000 per year, the return would be:
($10,000 for 1000 shares) x ($100 per share) = $10,000/$100,000 = 10% annual return,
which would not be enough. Unless the 3-month calls were selling for at least $500 each, or $5000 every three months for 1000 shares, it would not be worth doing.
2) It is generally not worth writing covered calls unless one holds at least 500 shares (1000 is better). Unless you hold enough shares to get a decent premium, the broker will make more than you do.
3) Write options further out-of-the-money if you want to keep the stock and think it will go higher. Write options more in-the-money if you think the stock is over-priced and really are just looking to sell the shares and get some downside protection. Obviously, the more in-the-money the shares are, the more likely you are to have the option exercised and your shares purchased at the strike price. If you think the stock has room to go higher, write the options at the next available strike price or above. You’ll get less premium, but are less likely to lose your shares and in any case will get more for the shares if they do end up being sold.
If you think the stock is overpriced and ready for a fall, writing in-the-money calls provides some level of downside protection and is really like selling the share at a little better price than they are currently trading (because the premium will normally be a little more than the difference between the current and strike price. Note that the IRS may consider the shares sold if the options you write are deep within-the-money, so check with your accountant if you are not sure.
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.
