If you already own a stock (or an ETF), you can sell covered calls on it to boost your income and total returns.
Income from covered call premiums can be 2-3x as high as dividends from that stock, and then you also get to keep receiving dividends and some capital appreciation as well.
This article will show in detail how covered calls work and when to use them, with examples.
Covered Calls 101
When you sell a call option on a stock, you’re selling someone the right, but not the obligation, to buy 100 shares of a company from you at a certain price (called the “strike price”) before a certain date (called the “expiration date”). They’re paying you for this option to increase their own flexibility, and you’re getting paid to decrease your flexibility.
Selling covered calls means you get paid a lot of extra money as you hold a stock in exchange for being obligated to sell it at a certain price if it becomes too highly valued. That will cap your upside, but will generate high income in the meantime, even in a flat or bearish market.
When to sell covered calls
Some buy-and-hold investors that buy stocks at a good price are willing to hold onto them for years and years even if they become overvalued.
I’m a long-term investor myself, and often hold positions for years. But there’s a line in the sand where if a company you’re holding simply becomes too expensive, it’s better to sell it and reinvest in an undervalued company. Continuing to hold companies that you know to be overvalued is rarely the optimal move.
On the other hand, there are one-tactic “covered call strategies” on the market, where all they do is buy shares of stock and sell covered calls on them. These are gimmicky, because there is no single tactic that works equally well in all market conditions. You usually wouldn’t want to sell covered calls when the market is very undervalued, for example.
Covered calls are a useful tool, and in the hands of a smart investor in the right circumstances, can be tremendously profitable. But they also have the drawback of capping your upside, so there are times when they’re not the right tool.
Here’s a good time to sell a covered call: when you can already calculate at what price your shares would be overvalued.
Rather than waiting for shares to become overvalued, and then sitting around deciding whether or not you should sell them, you can plan this in advance.
You can determine the fair value of businesses you own, and sell covered calls at strike prices that are substantially higher than those fair values.
That way, you generate a ton of extra income from them while you hold them, and then sell them when they become significantly overvalued. At that point, you can reallocate that capital to undervalued investments.
Suppose you bought 100 shares of a stable dividend-paying bank years ago at $30/share when you considered it to be undervalued, and back then it was paying $1/year in annual dividends out of $2 in earnings per share.
The dividend yield was a respectable 3.33%. The bank had the highest credit rating in its industry, was growing at a respectable pace, weathered the 2008 financial crisis reasonably well, and was a great investment at its earnings multiple of 15 at the time.
But now three years later it’s up to $45/share and paying $1.25/year in dividends, and you no longer consider it undervalued.
It’s at a higher P/E than it was when you bought it, its dividend yield is lower at only 2.77% due to the stock price increasing faster than the dividend growth, there’s no new catalyst for extra company growth or anything like that, and it’s not something you’d buy today if you were looking for a new stock. It’s still a great company, but not at a great price.
You’re only sticking with it because you already have it, it’s not too overvalued, and if you sell it you’ll trigger a capital gains tax unless it’s in a retirement account.
This fair price calculator from OptionWeaver shows that it’s most likely worth less than $42/share:
You could just stick with it for now, and just keep collecting the low 2.77% dividend yield and maybe having some more price appreciation. It’s already mildly overvalued though, so price appreciation is probably limited for a while.
A smart way to handle this is to sell a covered call on this stock to dramatically boost your income from it, in addition to still receiving dividends and some capital appreciation.
Here’s a call table for 4-month options on this stock:
Click here to see a bigger image.
Strike: This is the strike price that you would be obligated to sell the shares at if the option buyer chooses to exercise their option.
Price: This is the price that the option has been selling for recently. This is basically how much the option buyer pays the option seller for the option.
Change: This shows you the recent changes in the option pricing.
Bid: This is approximately what you’ll receive in option premiums per share up front if you sell the call. A market maker agrees to pay you this amount to buy the option from you.
Ask: This is what an option buyer will pay the market maker to get that option from him. The difference between “bid” and “ask” is the market maker’s profit. He’s the middle man between option buyers and sellers that makes this a liquid market.
Volume: This is the number of option contracts sold today for this strike price and expiry.
Open Interest: This is the number of existing options for this strike price and expiration. It’s the sum of all option volume leading up to today, minus any option positions that were closed prematurely.
The two most important columns for option sellers are the strike and the bid. The strike is the amount you’re agreeing to sell the shares for if the option is exercised, and the bid is roughly the amount of premium you can expect to earn when you sell the option.
As you can see in the picture, there are all sorts of options at different strike prices that pay different amounts of premiums. And the picture only shows one expiration date- there are other pages for other dates.
In this example, the option that stands out to me as a good choice is the one with a strike price of $47. It’s substantially above the current stock price of $45 and offers a decent premium bid price of $0.85.
Let’s go with this one:
Click here for a bigger image.
If you sell this option, it means you’ll receive $85 now from the option buyer, and you’ll be obligated to sell all your 100 shares of this bank at $47 each if the buyer wants, for a total of $4,700, any time before the expiration date of the option in 4 months.
If you sell several options, you’ll be obligated to sell several hundred shares. Each option is for 100 shares.
So, let’s say you sell this option. Here are your inputs, as well as the potential outputs of what can occur, courtesy of OptionWeaver:
Possibility A: The stock stays under $47 at expiration
If, over the next 4 months, the bank generally stays under $47/share, the option buyer will likely not exercise her option, since there would be no reason for her to force you to sell your shares to her for exactly $47/share when the market price is already under $47/share. Her option will expire worthless, you’ll keep your $85 premium, you’ll keep your 100 shares, and you’ll keep any dividends paid during this holding period.
With the option now expired, you’ll be free to sell another one. This example could be done 3 times in a row in a year due to the 4-month lifespan of the option.
Consider that the annual dividends paid by this company are currently $1.25/share, or about $0.3125 per share per quarter. During this 4-month option lifespan, you likely received one dividend, or possibly two, for a total of $0.3125 to $0.625 in dividends.
This option earned you $0.85/share in premiums for the same period, which is far more than the dividend and is in addition to the dividend. Over the course of a year, selling a similar option three times would give you $2.55/share in premiums, which is twice the amount of the $1.25 annual dividend total.
What this means is that you effectively tripled your dividend yield from this stock, because you’re receiving the dividend in addition to the call premiums which are twice the size of the dividends in total.
Over the course of the 4-month option lifetime, the stock can rise as much as $2/share without it hitting the strike price, so you still have room to make good capital appreciation. In fact, that would be a 4.44% stock increase in 4 months, or 13.33% annualized.
And let’s say that at expiration of this option, the stock is now at $46, so it increased a buck over where it was 4 months ago, and paid you dividends along with your option premiums.
When you sell your next option to do this again, you can sell for a higher strike price of perhaps $48, to give yourself more room to keep holding it. The option premiums set by the market will constantly adjust as the stock price moves upward or downward, so when the stock price is $46/share and you sell calls for a strike price of $48, you’ll get similar option premiums as you did this time when the stock price was $45/share and the call strike price was $47.
As you sell these covered calls, your dividend yield will be around 2.77% ($1.25/year), and your call premium yield will be about 5.66% ($2.55/year). Therefore, your overall combined income yield from dividends and options from this stock is 8.44% plus the potential for double-digit capital appreciation up to 13.33% annualized.
If the stock price goes down a bit, maybe to $40 a share or so, that’s okay too. You’re collecting huge dividend and option income from the stock, and you’re holding it for the long term until it becomes too overvalued.
All of this on a nice, blue chip, stable bank with the highest credit rating in its industry.
Possibility B: The stock ascends over $47 at expiration
If, over the next 4 months, the bank ascends to over $47/share, the option buyer will likely exercise her option to force you to sell 100 shares to her at $47/share. So, if the stock is trading at, say, $50/share at this point, she’ll be buying them from you for only $47/share.
You’ll sell your 100 shares for $4,700, and you’ll also keep the $85 option premium and any dividends paid by the company during that time.
You’ll have made:
$2/share in capital appreciation
$0.85/share in option premiums
$0.3125 or $0.625 in dividends
…for a total of $3.16 to $3.47 in gains per share on your $45/share principle.
That translates into a 7% return over a 4 month period, or 22.5% annualized.
Usually you’d be happy with this outcome even though you otherwise might have been able to sell for a bit higher, because now you likely consider the stock overvalued anyway, and its dividend yield will likely be even lower than it was at $45. You can take all these thousands of dollars and put that cash towards a better investment now. Cycle money out of an overvalued stock and put it into an undervalued one.
The only scenario where you’d probably be sad with this outcome is if the bank were acquired by another company, and rose dramatically to, say, $60/share. You’d lose out on a lot of that upside as you’re forced to sell your shares at only $47. This would be a rare outcome, since stable blue chips are only acquired once in a blue moon, and remember, you still had a 7% return over just 4 months even if theoretically you could have had more!
Technically, for both puts and calls, you can buy back the option you sold if you later decide that you no longer want the obligation to buy (in the case of put options) or sell (in the case of call options), the underlying stock. Depending on the price changes of the stock, the option could be cheaper to buy back than it was when you sold it, or it may be more expensive.
Pay attention to dividend dates
Before you sell a covered call, look up the historical dividend payouts of the company.
To do this, I personally just google the phrase, “XYZ dividend history”, with XYZ being the ticker symbol.
One of the first search results will be Nasdaq’s page on the dividend history of the company, which is the easiest source.
You’ll find a chart like this, but longer. I cut it short for brevity:
The most important dates on the chart are the Ex/Eff Dates, aka Ex-Dividend dates. Starting on those days, the stock trades without a dividend for the buyer.
In other words, if you sell this stock on 9/27/2016, the buyer of the shares gets to receive this upcoming dividend. But if you sell this stock on 9/28/2016, the buyer was too late and the seller receives the dividend. On 9/28/2016, the stock trades “ex-dividend”, meaning without that particular quarterly dividend.
As a holder of these shares, you’ll want to check to see which dividends you’re entitled to during the period prior to selecting the call option you want to sell. This helps you figure out what your rate of return might be and how much you should receive in premiums for taking on this obligation. Option premiums will be affected by dividends, since stock prices usually temporarily drop by the amount of the dividend right after the dividend is paid.
Covered call risk profile
Here is the risk/reward chart for your covered call:
As the chart shows, you’re capping your short-term upside potential, in exchange for extra income and a small amount of downside protection.
But remember, you’re only doing it at strike prices that you consider overvalued anyway. If the option triggers a sale, you can take that money and reinvest it into something that’s undervalued.
A stock holding with a covered call on it is slightly less risky than holding the stock normally, because your downside potential is slightly reduced by an amount equal to the option premium. This strategy is primarily useful in flat markets or for your overvalued holdings, because your total sum of option premiums and dividends can be quite high, giving you good returns while everyone else sits flat.
Unless you sell in-the-money covered calls on your positions, though, you won’t have as much downside protection as you get with selling puts at strike prices below current market prices. So compared to that strategy, this is often a slightly more bullish one.
Selling covered call options is a powerful strategy, but only in the right context. Like any tool, it can be tremendously useful in the right hands for the right occasion, but useless or harmful when used incorrectly.
Gimmicky strategies of covered call buy-writing are not necessarily the best way to go.
The best times to sell covered calls are:
1) During periods of market overvaluation, where the market is likely to be flat or down for a while. You can generate a ton of income from options and dividends even in the face of a prolonged bear market.
2) For slow growth companies, so you can maximize your returns from a combination of dividends, call premiums, and capital appreciation from the company’s share purchases and slow organic growth.
3) When one of your stock holdings is becoming expensive relative to its fair value. Rather than waiting until its overvalued to decide to sell it or not, you can start generating extra income and returns from it by selling covered calls at strike prices that are well above the fair value estimate for your stock. Then, if it ends up ascending pass your strike price, forcing you to sell it, you can reallocate that capital towards more undervalued investments.