As I discussed in the first part of my options series, investors typically perceive options to be very risky and highly speculative. While this certainly true in many circumstances, that's not to say that it's impossible to use options of options to leverage an investment strategy.
While I focused on puts in my last options article, in this post I will focus on covered calls. Covered calls are the sale of call option contracts when you own the underlying stock, and therefore you are "covered." Unlike puts, where the option is exercised if the stock hits a predetermined price lower than the current price, calls are exercised if the stock hits a predetermined price higher than the current price.
Although covered calls have several different potential applications, in this post I'm going to focus primarily on one specific application -- generating income on a stock you would like to hold.
For many investors, constant buying and selling of stocks is unrealistic and undesirable. In fact, there is tremendous evidence to suggest that the more active an investor is the worse his returns are. As a result, many investors don't know what to do when a company they desire to hold reaches a price that they consider to be overvalued. Part of the investor believes over the long term the company's intrinsic value will continue to increase and he will regret selling now. But part of him wants to monetize the recent rally in the stock's price. In this situation, selling covered calls makes great sense.
This is often the case for investors who purchase growth stocks that, when purchased, they didn't consider to be ridiculously valued. For example, investors who purchased Apple Inc. (NASDAQ: AAPL) several months ago who now hold 50%+ gains are probably considering trimming their position, a move I'd consider prudent. If this investor believes the company will be able to continue growing its intrinsic value with time as a result of new product lines, continued success in existing markets, and so forth, then he probably doesn't want to sell his stock at current prices. This investor should look at covered calls.
For example, he could consider selling January 2008 $170 on maybe half his position. These calls, which trade for $10.10 each, are interesting for this investor for a couple reasons. Let's say he owns 200 shares of Apple; if he sold 1 options contract he'd stand to quickly make $1,010 in cash. Worst case, to justify being called on this position the buyer of the contract would have to wait for the stock to hit $180.10. If this occurred, he would have made $30 more per share than if he sold now ($180.10 - $1.70 vs. $143) and still own half of his position in the company. If the stock does in fact pull back, at least the investor was able to make $1,010 (roughly $5.10 per share) without losing control of the company he believes in.
So covered calls offer two primary benefits over an outright sale if you believe in a company's long term potential:
- Allows the investor to earn more potential upside in the stock.
- Allows the investor to retain control of the stock and earn money on the position even if the stock falls.
One application of covered calls I won't really cover is the concept of buying and subsequently writing calls on the position. Theoretically, this makes sense when the market is overvaluing volatility, which the options salesperson believes is overdramatized. This strategy is already being employed by a variety of closed-end funds such as Eaton Vance Buy-Write Income Fund (NYSE: ETB), which has had modest success, and it pays a solid dividend.
Covered calls, like cash-secured puts, bring new options to the table for investors of pretty much any kind -- from a dyed-in-the-wool value investor to a hype-loving momentum investor.
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Reader Comments (Page 1 of 1)
1-03-2009 @ 11:13AM
Fred Thompson said...
This is a great article. As a long term covered calls trader, I can see the benefit of selling OTM calls on long term stock position. Also, any covered call trader will need some sort of tool to help him make decisions on when to manipulate his positions. A great tool can be downloaded at www.coveredcallcalculator.net
8-24-2007 @ 11:24AM
Al said...
Why wouldn't someone just put a "stop" on a stock and as it appreciates, increase the stop? This sounds simplier then "covered calls"
8-20-2007 @ 10:21AM
Kevin Kelly said...
That's an interesting question. I think that covered calls are quite different, especially because you receive a cash payment but still maintain your ownership in the stock.
To each his own...
8-25-2007 @ 3:17PM
Jason said...
I found your article very interesting. It reminds me allot of what the people over at compound stock earnings.com say.
I referenced you on my recent article about covered calls on my blog, http://finance.jasoncrews.name. It will be up in a couple of days, let me know what you think!