How Selling Calls Can Lower Your Investment Risk

In my last article, I went over the basics of trading options, including an example of selling a put. Now let’s look at how to safely sell calls on stocks of which you own at least 100 shares.

Covered Calls

Selling covered calls on your stock is also known as “writing covered calls,” and it means selling calls on securities that you actually own (as opposed to “naked” selling, which means selling a call on a security you do not actually own and is much riskier). Just as with puts, people who write covered calls are given premiums in exchange for their risk. What’s the risk? The risk is that the stock they own may trade far above the strike price, and thus someone may exercise the calls. If that happened, the call writer would have opportunity loss. Just like in the first housing example in my last article, the home seller missed out on selling his house at a higher price ($840,000) because he had entered a call contract for $800,000.

Let’s say one owns 1,000 shares of MSFT at $57, and writes covered calls for one September 60’s—that is options lingo for a strike price of 60 with the expiration on the third Friday of September—and gets paid $2 per share for the call. Then that stock subsequently moves to $80 by the close of trading on the expiration date, the call writer has an opportunity loss of $20 a share (the difference between $60 and $80), or $2,000 (mitigated down to $1800 by the gain from the options contract premium payment of $200 or $2 a share).

If the stock reaches the call strike price, a few things can happen:

1. If it reaches the strike price sometime before option’s expiration date, the call writer may be “called out” and lose his stock at the strike price. This happens on occasion and at the whim of the call buyer, but it can happen. Normally calls are not exercised until the expiration date.
2. If the stock is trading $0.01 above the strike price at the close of regular trading hours on option’s expiration date, the broker will “auto-exercise” the option and the call writer will lose his stock at the strike price.
3. If the stock reaches the strike price sometime before options expiration date, the call writer may choose to “buy back” (buy to close) calls to remove his obligations on it. He would have to buy the contract out at its market price (likely a higher price than what he sold it for).

I recommend keeping your eye on your stocks daily or speaking to your broker to understand how to notify you once you have been assigned a position.

Don’t think that you need to constantly watch the market. I do recommend that you take a look at your portfolio once daily. Again, if you are able to bring in returns of 15+% a year, I would say the 5 minute daily check up again your portfolio is well worth the time.

If the stock comes close to the strike price on options expiration day, then the call writer made money (premiums) for just providing an offer to sell his stock. That’s not a bad deal.

If this strategy is employed correctly, it’s really not a tragedy if the call-writer gets called out before or on options expiration day. After all, he made instant “guaranteed money” for writing the calls. And, if he chose the correct stocks, the stock should not move too far above the strike price. Let me explain.

The most effective way to use this strategy is to look for stocks that are “range-bound,” or may soon hit resistance. We would not be interested in stocks rocketing upward, or downward. This strategy is not as effective when the market is in raging bull conditions, very bearish, or acting erratically. The best market condition is when the market itself is stable, and not falling hard, or rising fast. This way, there’s less chance of “opportunity loss” or downside risk.

Let’s assume I now own the stock Sarepta Therapeutics Inc. (SRPT) that I originally sold a put on in the example from my last article. Now that I own it, we want to sell a call, so I look up an option chain online or with my broker to decide what strike I would like to sell.

In this case, we will assume that I am comfortable selling a call on a May expiration 16 strike. By doing so, I am able to collect $5.00 of premium (the further out in time to expiration you go, the more premium you will collect). I also get a 35% downside protection; a 52.9% return if the stock remains flat, and a 184% annualized return. (I’ll explain how to calculate and compare returns in the next section.)

Below is a short snapshot of the potential returns we would have collected by selling a call on SRPT:

If we selected a stock that paid dividends, we would even further increase our returns.

Calculating ROI

There are several types of profit calculations used when calculating covered call returns.

Return If Flat is the return % if the stock price remains unchanged (flat) between now and option expiration. It equals the time premium divided by the net debit, which is what you paid to own the stock less the premium.

Example: You buy 100 shares of stock at $39 and sell an OTM option with a strike of 40 for $2/share. Net debit is $37 (39 – 2) so your account is debited for $3700.

If the stock stays flat (it’s $39 on expiration day), your account is worth $3900 (you have 100 shares of a $39 stock) and you had invested $3700 at the beginning, so the return is the time premium divided by the net debit: 2 / 37 = 0.054 or 5.4%.

Return If Called is the return % if the option is exercised and the stock is called away. It equals the difference between the strike price and the net debit, divided by the net debit.

If the example option is exercised, you receive the strike price in cash (40), so the return is what you got minus what you invested, divided by the amount you invested: (40 – 37) / 37 = 0.081 or 8.1%.

In order to fairly compare covered call returns where the options have a different number of days until expiration, investors use Annualized Return:

Annualized Return If Flat is the annualized version of Return If Flat.

Annualized Return If Called is the annualized version of Return If Called.

To convert from Return to Annualized Return you need to know the holding period. For example, if you make 1% in 30 days, that would be about 12%/year. Divide the Return by the holding period (measured in days) and then multiply by the number of days in a year (365). Compare the same investment for 3 different holding periods:

Benefits of Selling Calls

This strategy generates additional income on stocks you own. Regardless of what the market does, you keep the premiums on the covered calls you sell.

When selling covered calls, you generate funds immediately. The money will be in your account within a day or two. It’s your money to do what you want with.

You make guaranteed rates of return. You’ll know the initial rate of return and the rate of return you’ll generate if you are called out.

Employing the strategy correctly can reduce your risk of going long in a stock because your “cost basis” is reduced by the covered call premium. If the stock was selling for $50, and you sold your calls for $2, your cost basis is now $48. The stock could fall $2 a share, and you’d still have a “flat” trade.

Risks of Selling Covered Calls

This strategy requires an underlying investment in stocks. You need to own a minimum of 100 shares of an optionable stock to use this strategy.

Selling calls can limit your upside. If your stock rises above your strike price, you could get called out and there may be opportunity losses.

You also have the downside of being under contract to hold your stock unless/until you remove that obligation. If the stock falls to a point where you want out (in our case, we’ll use 50% of the initial call value), you will have to buy back (buy to close) the calls and sell the stock (remember to set your alert at 40%).

Finally if you get called out of a stock and you have a gain on that stock, the gain will be subject to Federal and possibly State taxes unless you have other losses to offset the gain.

Conclusion

Over these last two articles, I hope I’ve convincingly shown you how selling puts & calls can safely boost your yield tremendously every year, and gives you much more control over your wealth.

In my next article, we’ll dig into research, and I’ll show you what I look for when I’m on the hunt for stocks.

 

Randall Bal is a professional swimmer and individual investor. Read our profile of him here.