Commonly referred to as the "most conservative option strategy
available," this technique has cost uneducated investors billions of
dollars since options were invented. Do not get me wrong: writing
covered calls can be a very profitable strategy when implemented
correctly. The Covered-Call and the Naked-Put (an equivalent
strategy) are consistently the most profitable strategies. It is all in the technique!
Generally, covered calls are written on stock an investor holds in his
portfolio. The concept is to produce cash flow by selling premium for
income while obtaining downside protection. The underlying stock
can be held in either a cash or margin account. The advantage of
trading on margin is that the potential return on investment is
doubled. The disadvantage of using margin is that additional capital
(margin call) may be required in the account if the portfolio value
falls below a certain percentage.
Many investors are very successful in this strategy because they are
not greedy. They understand the "magic" of compound interest and
strive to consistently increase the value of their investment portfolios
each month. Others constantly lose money by implementing the
The term "covered" is used when describing the sold (short) calls in
this strategy because the investor owns the stock on which he is
writing the calls. For every 100 shares of stock the investor owns, he
can "write" one (1) call-option contract. Typically, investors will pick
the next strike price above the current price of the stock to maximize
the potential return on investment. A conservative investor will pick
an in-the-money (ITM) strike price, choosing an acceptable return
that offers reasonable downside protection. Aggressive investors
tend to focus on the higher returns of using out-of-the-money (OTM)
strike prices at the expense of downside protection. These OTM
positions do offer greater "potential" rewards, but depend on an
increase in price by the underlying stock and do not really benefit
from writing the call.
Return On Investment
The target-yield or return on investment (ROI) for covered calls is
determined by two circumstances: Return if Called (RC), and return
not called (RNC). Most traders use the RNC to evaluate plays since
there is no assumption made on the movement of the underlying
equity. To calculate the return, you take the net premium received
and divide it by the cost basis. The cost basis would be the price
paid for the stock, minus the premium received; this is the maximum
amount of equity required for the duration of the play (not using
margin). We use generally accepted formulas to calculate the return
as shown below.
For an ITM covered call, the net premium would be the option
premium received minus the difference between the cost of the stock
and the strike price. ITM RNC will be the same as RC, since the sold
strike is already "in-the-money," and is the maximum return
XYZ @ $12.00, strike = $10.00, option premium = $2.50
Net premium = 2.50 - (12 - 10) = 0.50
Cost basis = 12.00 - 2.50 = 9.50
RC = 0.50/9.50 = 5.26% after multiplying by 100.
RNC = the same.
For an OTM covered call, the net premium for a RC calculation would
be the option premium plus the difference between the cost of the
stock and the strike price and assumes the stock price will move up
to the sold strike! An OTM RNC calculation uses only the option
premium and assumes the stock price remains unchanged.
XYZ @ $12.00, strike = $12.50, option premium = $1.00
Net premium = 1.00 + (12.50-12) = 1.50
Cost basis = 12.00 - 1.00 = 11.00v
RC = 1.50 / 11.00 = 13.64%
RNC = 1.00 / 11.00 = 9.09% (You do not get the benefit of the
stock price moving up to the strike price).
Successful investors choose ITM covered call candidates as the goal
is to obtain the highest probability of making an acceptable (and
Let us look at an example. An investor holding a $16 stock could
possibly write three different calls: the $15 call for $1.75; the $17.50
call for $1; and the $20 call for $0.50. Notice the ITM the position
($15 strike price) offers a maximum return of 5.26%, even if the
stock price dropped a $1.00. Generally, when comparing covered
call positions, investors concentrate on the return achieved if the
stock price remains unchanged. In this manner, no assumption is
made regarding the future movement in the underlying equity and
the overall position reflects the benefit of just selling the call.
The cost basis is important as it identifies the break-even point and
the amount of downside protection. As you can see the $17.50
strike offers a slightly higher "static" return but only half of the
downside protection of the $15 strike. Clearly, the $15 strike offers
the best of both worlds; a reasonable return with acceptable
Why choose OTM positions? It simply depends on your risk-reward
tolerance. If you are that good at picking stock movement, wouldn't it
be better to just trade the stock instead of capping your potential
profits with a covered-call position?
Writing Covered Calls: The Drawbacks
Assume you bought a stock at $50 that had fallen substantially (to
the $20 range and you were trying to recover some of your losses by
writing OTM covered calls. If the stock unexpectedly rises above the
sold strike price (say a $30 strike) at expiration, the issue would be
called away and you would have locked-in a loss.
Or, assume you bought a stock at $10 a few months ago and now
you think it is going to $50. You want to hold it for the long term but
you would also like some downside protection. You sell some short term
OTM calls to generate cash flow but the stock climbs very
quickly and is called away. Not only did you lose your stock, but
incurred a short-term capital gain as well. You did make a profit but
it is now taxable at a higher rate.
Consider the following examples:
Let us say you bought the stock in the chart above to hold long-term and you hope it will return to its highs at $50. The stock has done nothing over the last two months and you decide to write the October $7.50 call for $1.00 while you wait for the stock to find a bottom. There is only three weeks left in the option cycle so you feel confident you will not be called.
Here is what happened to that OTM position:
You wrote those covered calls a couple days before the stock caught fire
on an analyst upgrade and began a rally that could take it to the $30 range. Seller's remorse sets in because the stock has risen 50% from the price at which you wrote the
calls. You made a nice profit on the call but in reality, it was less than half of
what you could have made simply holding the stock. If you are
bullish on a company and do not want to lose the stock
DO NOT sell covered calls. Many investors discard the covered call
strategy because they cannot stand to limit their profits.
There are worse things that can happen to a covered-call writer than
taking a small profit and missing out on a bigger one. A common
idea is to write covered calls to minimize losses on stocks that have
become bearish and are trending down. I cannot tell you how many
times I have heard the phrase: "I will just write calls on it until I get
my money back." This is an interesting concept but a failing strategy
in my opinion, as the attempt to recover lost share value often
results in a locked-in loss. If you become bearish on an issue, it is
usually best to simply buy back the calls and sell the stock. Why tie up
your money in a low-probability effort at recovery.
If a stock drops $20 or $30, how many months do you have to write
calls on it until you get your money back? Assume the stock has
fallen from $50 to $25 and you don't want to be called-out and incur
a loss. With a $25 stock, you can expect the OTM option premium
to sell for about $1. Remember, you don't want to be called away so you have to write OTM calls. Thus, in the best case scenario, you
will have to write OTM calls (at $1 each) for 25 months AND NOT
BE CALLED OUT in order to just BREAK EVEN. That is 25 months
of more risk to achieve a break-even exit. Your risk is not only being
called-out but also the potential for a future decline in the stock
price. How many months would you have to write covered-calls on
the stock below to recover your money if your cost basis was $50?
There are no covered calls you can write on a $1 stock.
NEVER PLAN ON WRITING COVERED CALLS AS AN ESCAPE PLAN!
Is it really a conservative strategy?
The Covered Call strategy is not foolproof as there is risk in all trading.
It does have less risk than outright stock ownership as the premium
received reduces the cost basis in the underlying issue. Still,
whether the covered-write strategy is applied short-term or longer term,
it requires a neutral to slightly bullish outlook on the underlying
equity and the overall market. As with stock ownership, you are still
exposed to the risk of a drop in the stock price. Almost every week
there are several stocks that drop double-digits on a negative news
event. The premium you receive for writing a covered call may not
be enough insurance to protect yourself against this risk.
There are ways to profit from the covered-call strategy with
I favor a very conservative approach and in
my opinion, that is the only way to use the covered-call strategy.
I always recommend writing ITM covered-calls as we are not
interested in stock ownership or bullish movement, but prefer the
higher probability of making a low yet reasonable return. The fact
that we really cannot predict stock movement reinforces my reasoning
for choosing to hedge stock ownership with ITM covered writes.
I generally target a monthly return near 5%. The ITM covered-call strategy usually requires a "buy-write" order to open the position at or near the listed net
debit (cost basis), since trying to leg-in (buying the stock and selling
the call later) may only see the overvalued premium disappear.
There are several things you want to remember when using
1. Never buy a stock you do not want to own.
2. Never write calls on a stock you don't want to lose.
3. Never write calls as a cost-recovery tool on a stock you do not
want to lose.
4. Always write covered calls on STOCK YOU BOUGHT FOR THIS
5. Always plan on being called-out EACH month.
6. Always write in-the-money calls.
7. Always write calls on bullish stocks.
8. Always use sound money-management techniques.
A Winning Strategy!
Is there a correct way to write covered calls? Here are two samples
of ITM covered writes:
On October 8th you could have written a November $35 call on BHP for $3.25. The call is already $2.32 in the money so your net if called away is 93 cents. If done on margin the return if called is 5% for a 6 week position. Your downside protection is $3.25 below the current stock price at $37.32. That means BHP would have to fall under $34.07 (-8.7%) before you lose money. That ITM premium received is insurance against an unexpected decline.
Another example would be the Analog Devices (ADI) November $55 call, currently $4.10. The call is $2.72 ITM so your net if called would be $1.38. If done on margin your return would be 5% for six weeks. Your insurance is $4.10, which means ADI would have to decline below $53.62 (-7.1%) before you lose money.
Earning 5% per month may not seem like "big" money but 60% per
year is definitely better than the average investor's return for almost
any other strategy. Many investors lose sight of the magic of
compound interest and start to focus on excellent single transaction
returns. In short, they become greedy!
Again, the key points in this strategy are as follows:
1. Use only on stocks you buy for this purpose
2. Write in-the-money calls to minimize risk.
3. Plan on getting called-out every month.
4. Write calls only on bullish stocks.
5. Maintain stop-losses on the underlying equity whenever possible.
There Is Risk In All Trading
Remember, there is no "Holy Grail" in option trading. Even with this
"conservative" strategy, it is possible to lose money. The probability
of loss is much lower with covered-calls but unforeseen events do
occur. Whenever possible, maintain a stop-loss on the
underlying issue to limit losses. Should negative news come out
during the day, or if the stock changes character, trading stops may
save you from needless loss and months of attempting to recover
In the event of a catastrophe like the EXAS event in the chart above,
there is nothing that will help. To reduce the impact of these
unavoidable events, we recommend that you never invest
more than 3% to 5% of your overall portfolio in one stock. This is
an important concept of money management -- so that one stock will
NOT have a significant impact on your overall portfolio value. No
one knows what a particular stock is going to do in the future unless
they have "insider" information. Therefore, you do not want to have
"one ship that sinks the whole fleet."
Even with one or two unanticipated, catastrophic events in a year, I
have found that a diversified ITM covered-call strategy, when used in
a disciplined manner, can generate a 30% - 40% yearly
return. The ITM covered-write strategy is for conservative investors
who prefer to target the high probability of obtaining an acceptable
return, which correlates with a low risk-reward tolerance. Greed is
for those other guys!
If you like the options education you have been receiving and you are on a free trial then now is the time to subscribe. Do not wait until you miss a newsletter to decide you want to take the plunge.