Who needs a bull market when you have the covered call strategy
US stocks have been one of the best asset classes to own over the past 3 years, with the S&P 500 rising by c.32% in 2019, followed by a credible 18% in 2020 amid COVID-19 and with just about 2 months to the end of 2021, the US index has already appreciated by more than 20% YTD.
Can we count on more stock market upside for the rest of 2021 and into 2022? Unfortunately, I don’t have a magical crystal ball in front of me, but my spidey senses seem to caution that there is not much of a market upside from hereon.
If those senses are accurate, and the market is not going to see much appreciation in the coming year, then it makes sense to hunt for a way to profit from a flattish stock market in 2022. The covered call strategy might just be the strategy to outperform the market in the coming year.
What is the covered call strategy?
The principle behind the covered call strategy is simple: you own the underlying stocks which allow you to partake in its upside. Concurrently, you sell a call option on those stocks and in the process of doing so, collect a premium upfront.
This is typically seen as a low-risk strategy of generating a steady stream of income. Do, however, note that structuring a proper covered call involves the ownership of at least 100 shares of the underlying.
If one sold a call option without ownership of (100 shares) of the underlying stock, that sale becomes a “naked” one which exposes one to significant downside risk if the share price appreciates significantly.
As a call option seller, one is “bearish” on the underlying stock akin to “shorting” the stock. Hence when the price appreciates instead, the losses could become substantial.
However, when combined with the ownership of 100 shares of the underlying, that short call option position is now being fully “covered” by the stock ownership. If the underlying price rises, losses incurred on the short call option will be fully compensated by the appreciation in the value of the stock.
If the ownership of the underlying stock counter is less than 100 shares, there will be a “mismatch” in terms of exposure (since each call option represents 100 shares) and a significant rise in the share price of the underlying stock counter will result in greater losses incurred by the short call vs. the profits from the long stock.
Quick example 1
Say, for example, Stock ABC is currently trading at $100/share and you don’t expect the counter to rise above $110 over the next 1 month.
You hence decide to sell a “naked” call option at a strike of $110, generating $5 in premium. Your breakeven in this case is $110 +$5 = $115.
If Stock ABC rises above $115 in the coming month, you will start losing money. If the price of Stock ABC is below $110 by the end of the month, you get to keep your full $5 in profits. Your profit will be between $0 to $5 if the underlying price is between $110 to $115 at the end of the month.
What happens if the price appreciates significantly to $150 by the end of the month?
As you have sold a call option at the strike of $110/share, you are now obligated to sell your shares at $110 and buy back from the market at $150.
After accounting for the $5 premiums, you received from the short call sale, your losses amount to $35.
Hence, the higher the price appreciates, the more your losses will become if you sold a “naked” call.
What happens when you have ownership of 100 shares of the underlying as well?
Your losses incurred on your short call will not be fully compensated by the ownership of the long stock.
Again, if the price appreciates to $150 within a month, you are now obligated to sell your shares for $110. However, unlike the previous example where you are essentially “shorting” the stock (since you have got no ownership in the first place and you are forced to sell at $110), you already have existing ownership of the underlying and hence, you are just required to give up ownership of that stock for $110.
You don’t get to sell at a better price of $150 as dictated by the market currently but neither would you incur substantial losses since the loss on your sell call option position is now fully offset by the profits from your long stock.
Losses from Sell Call = $110-$150 = -$40
Profit from long Stock = $150-$110 = $40
Net profit/loss = $0
When you structure a covered call, you are simply passing up on the potential upside of buying and holding. If the price breaches the strike level and the buyer of the option exercises the right to buy, you simply transfer the stock you already own to the buyer and you no longer have any existing position.
You get to keep the premium received from the sale and your profit from the share sale is equivalent to the strike price – cost price of your stock purchase.
If the price remains below the strike, the buyer of the option will not have the incentive to exercise it and you get to keep your stock plus the premium you received from the call option sale.
Why would you give up the upside?
It might be evident to you by now that such a strategy will entail potentially forfeiting significant share price upside if the counter appreciates more than your sell call strike during the option contract horizon.
You are now obligated to sell your shares at the strike price and no longer able to partake further from the counter’s share price appreciation.
In return for potentially forfeiting this capital appreciation, you receive a premium upfront.
This is thus a strategy to generate short-term income from the premium received, while yet concurrently holding onto the stock as you believe in the counter’s long-term appreciation potential. You will still be able to participate on the upside if the counter’s appreciation is not as rapid as you expect.
Quick example 2
Say for example you believe that Stock XYZ has got good upside potential in the long term but the appreciation potential in the short term is limited, with short-term technical headwinds present. The counter is currently trading at $100/share and you believe that over the next 1 month, it will not go above $105. Your cost of the stock is $90/share
Hence, you sold a short-term (1 month) call option at a strike of $105, receiving a premium of $5 in the process. Stock XYZ appreciates to $104 on expiration day and your sell call expires worthless (since it is below your strike of $104). With the current price now at $104, you proceed to sell another short-term (1 month) call option at a new strike of $110, receiving a premium of $4.
If Stock XYZ continues its gradual appreciation and closes at $109 when the call option expires, you get to keep your full premium and can continue the next round of call option selling at a higher strike price. The cycle continues.
When done right, this allows you to partake in the stock’s gradual price appreciation while continuing to generate short-term income (through the sell call process).
Say, instead of closing at $109, Stock XYZ closes at $115. You are now obligated to sell your underlying shares at $110.
Capital appreciation from stock = $110 (sale price) – $90 (cost price) = $20
Income generated from sell call = $5 (first round) + $4 (second round) = $9
Total profit = $20 + $9 = $29
Risks involved in the covered call strategy
First, a covered call strategy won’t protect you from a sharp fall in the underlying stock price. Your losses will be reduced by the premium that you received from the short call but in the event of a drastic sell-off in the underlying shares, you will still be hurt by your stock (at least 100 shares) ownership.
Hence, the covered call is not exactly a hedging strategy but should be used as an income strategy. One in which you remain bullish on the counter for the long-term but wish to generate some short-term income out of your holding.
Second is the opportunity cost if the underlying share price goes up sharply. You won’t be losing money since the underlying stocks you own (at least 100 shares) will offset the losses on your short call option, but you won’t make a profit either.
This means that you will underperform a buy-and-hold strategy in a strong bull market.
Take note that your risk-reward will be skewed. You have a similar risk profile vs. a simple buy and hold strategy but your upside is now capped vs. a buy and hold strategy. Not exactly ideal.
Third, there is some active management involved (not a lot) but you will need to “recycle” your sell call options when they expire worthless (ideally) every month.
What should you think about before implementing this strategy?
Which security should you apply the strategy to?
This strategy can be used on any stock counter but my ideal counters to execute a covered call strategy on is for high dividend-paying stocks with good (but gradual) long-term appreciation potential.
Firstly, ownership of the underlying stock will entitle me to the dividends paid out by the company.
Secondly, I will ideally like to continue owning this stock with good long-term potential but I wish to avoid one where the short-term price appreciation might be too drastic (growth counters) such that it appreciates significantly above my sell call strike and I might be forced to relinquish ownership of the stock prematurely.
Hence, I tend to avoid executing covered calls on growth stock due to their volatile nature. The exception is if the growth stock that I own is now very profitable and I am comfortable in “taking profits” on the counter. I will then structure a covered call and collect premiums from this trade. If the price happens to appreciate above my sell call strike, I am prepared to close out my profitable trade on this growth stock.
How far out of the money should the strike price be?
There are a couple of ways in which I would select the strike price for my sell call.
First is using technical where a key resistance level is being identified and I believe that the potential for the counter to appreciate significantly beyond this resistance level is low. I will hence structure my sell call strike at that key resistance level.
The second is using delta. Delta represents the appreciation of the option price for every $1 appreciation of the underlying. So, if the underlying price appreciates by $1 and the option strike that you select increases in its value by $0.50, that particular option strike has a delta of 0.50.
However, delta is often used in option price selection as well and typically, I would look to select an OTM call option (delta between 0 – 0.5) for my sell call strike.
How far out in the future should the option’s expiration be?
Typically when structuring an option sale, it will be ideal to structure one where the contract horizon is short (less than 2 months). This is due to the effect of “theta decay”. The option value will fall faster as the maturity approaches. This is when as an option seller, theta decay is playing to your benefit.
You want to be selling and receiving a high premium and subsequently, buyback that premium as close to zero as possible. The faster the premium decays to zero, the more beneficial it is for you as an option seller.
This suggests you want to sell options with a relatively short expiration (think more of weeks instead of months).
What should your coverage be?
As earlier mentioned, to structure a proper covered call strategy, you need to own at least 100 shares of the underlying stock if you wish to be fully protected from a drastic increase in price since each option contract represents 100 shares (cannot be less).
Many new traders made the mistake of owning less than 100 shares of a counter when selling 1 call option contract or selling multiple call options when the underlying share ownership is only 100 shares. Such a scenario will result in substantial losses when the price appreciates.
Conclusion: Is this strategy the right one for you?
If your strategy is to provide you with downside protection, then this strategy is not ideal. The income generated from the premium received can help to offset some losses but it is not sufficient to cover your losses in the event of a drastic price decline.
Similarly, if you are extremely positive on the counter in the short term and believe its share price will continue to appreciate strongly, then this strategy which caps your upside potential, is also not going to cut it. You are better off just holding onto the stocks.
But if you think that the upside in stocks is limited given how high valuations are, or if you think that the Fed’s tapering action will lead to range-bound stocks in 2022, this could be an interesting way of keeping your stock exposure while adding extra short-term returns.
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