This is a guest post from Gavin McMaster @OptiontradinIQ
Searching for income has become a challenge. Bonds have been a traditional conservative income stream for decades. Yet, bond yields are now trading at historic lows. This has led some investors and advisors to jump into lower credit “junk” bonds simply to generate any income – a risky proposition. Yet along with dividend stocks, there are still ways to generate additional income in a portfolio. One simple way is by using options. The covered call allows investors to generate yield while reducing the risk of an overall portfolio. This makes it ideal for conservative investors or those seeking an additional stream of income. This article will explore the use of covered calls in a portfolio to generate additional yield.
The Covered Call
The covered call consists of the following:
- A position in a stock you like to own.
- A call option sold on that stock.
Let us look at it visually. The pink line shows the instantaneous profit and loss, while the blue line shows the profit and loss at the expiration of the call contract.
In this example, with Pepsi trading at $155.37, we have long shares of Pepsi and have sold the 160 Call for a premium of $2.85 to create a covered call. In this trade, we have three possible outcomes.
- The price of Pepsi stays unchanged. We collect the premium from the call and are break even on our shares for a slight gain.
- The price of Pepsi falls. We lose money on our shares but still receive the premium from the call option we sold.
- The price of Pepsi increases past our 160 call strike. Our profit on our shares is capped at $160 plus the premium we received. Our shares will be assigned.
In the first two scenarios, we are better off selling the covered call than simply buying the shares as we collect the $2.85 premium. It is only in the third situation in which Pepsi increases dramatically that the shares make more money than the covered call.
By selling a call option, an investor receives a premium from the buyer of the option. If the stock price remains below the strike price of the call, the options seller simply pockets the premium. If the stock price goes above the strike price, the seller provides the shares to the buyer and makes the difference between the share price and the strike price, plus the premium received.
In return for providing a service and forgoing some upside potential, an investor is rewarded with a steady income flow, with some limited downside protection. This makes covered calls one of the favorites to trade for investors looking to add yield to their portfolio.
Trading covered calls both reduces risk and improves the long term Sharpe ratio of a portfolio. This is because, over long periods, options are usually overpriced. This phenomenon is known as the variance risk premia.
Tips for Selling Covered Calls
There are several things to keep in mind when choosing to sell covered calls
- Only sell covered calls on stocks you are bullish on
Some investors like to sell covered calls on highly volatile stocks with shaky fundamentals. While this does collect more premium, it still does not ignore the fact you are long shares of a poor company. The biggest risk to a covered call is not having your shares assigned but the price falling to zero. In this situation, you lose everything apart from your premium. If you are not bullish on a stock, a covered call is not a good option.
- Understand that your shares may be called away
The reason we get a steady income from covered calls is that our shares may be called away. If you are not willing for this to happen, either due to fundamental reasons or tax considerations, avoid selling covered calls. There is no use giving up profits at 10% if you think an underlying will move 30%.
Nevertheless, even if your shares are called away, remember you can always buy the stock again. If it is for tax considerations or you simply want to continue to participate in the upward movement of the stock, you have an additional choice. You can always buy back the call you sold to avoid assignment and continue to benefit from future gains to the stock.
- Trade liquid options
The options market is much less liquid than the stock market. For investors wanting to sell covered calls on most S&P 500 stocks and ETF’s, there is usually no issue. Though for more illiquid holdings, it is better to avoid trading options as it increases transaction costs and could lead to expensive trade errors.
- Understand the risk
While covered calls are a more conservative strategy than simple buy and hold investing, there is still significant risk. In sharp market corrections, investors will be left with only small amounts of premium relative to losses on their shares. While they are still better off than their buy and hold counterparts, once the market reverses, they can have their shares called away, missing out on a substantial part of the rebound.
How Often Should I Sell Covered Calls?
There is no “best” time till expiry for selling covered calls. More active investors may want to sell shorter-dated, monthly options. While the premium is smaller, the process can be repeated more frequently. As variance risk premia is higher in shorter-dated options, this could result in slightly higher profitability in the long run.
In contrast, investors who do not want to manage their portfolio frequently may consider selling longer-dated options with a few months till expiry. This requires less management and reduces transaction costs over time.
What Delta Covered Calls Should I Sell?
Generally speaking, investors like to sell out-of-the-money options to capture some appreciation in share price without having their shares being called away. For most investors around the delta 20-30 calls will be a nice sweet spot.
More conservative investors can consider selling at-the-money calls which will have much larger premiums and therefore offer a bit more downside protection.
How much Income Can I Expect From Selling Covered Calls?
Covered calls can generate substantial amounts of income, sometimes over 10% annually. While this sounds impressive, it is important to remember that capital gains will also be muted as upside gains are limited. On the other side, an investor is still on the hook for losses. Overall annual returns in the long term should average out to be comparable or slightly lower than stocks but with less variance.
Covered calls offer investors an alternative source of income. This is especially valuable in an era of ultra-low interest rates. Furthermore, they help reduce the equity risk of investors in exchange for foregoing gains beyond a certain level. For conservative investors and investors seeking income, the covered call can be the perfect introduction to options. Better yet they can be placed without changing the composition and equities in a portfolio.
We will be running a free webinar on Thursday September 30th – Generating Income Using Covered Calls And Credit Spreads – You can register here.
Byline: Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. Follow him on Twitter at @OptiontradinIQ or his website at OptionTradingIQ.com.