Selling calls on stocks you already own is a great way to increase your yield on those stock positions while providing you with downside protection and reducing your cost basis.
1. Definition.
A call option gives its purchaser the right to buy a stock at a given price (strike) during a certain period of time (maturity). Conversely, the seller of a call option has the obligation to sell the stock at a given price (the strike) if the call is exercised before the end of a certain period of time (maturity). The seller is compensated for this obligation by receiving money at the time the obligation is assumed (i.e. when the call is sold). This premium is a function of 6 variables: the current underlying stock price (the spot), the strike price, the maturity, the implied volatility of the stock, the dividend of the stock, and interest rates. The seller keeps the premium whatever happens, unless he decides to buy back the call at a later date to be relieved of its obligation. The timing of call selling is therefore important: a seller will want to write the call at a time where the premium will be inflated, after a spike in the stock price for instance.
Selling a covered call, also named “buy-write” is the process of both buying a stock and selling (“writing”) calls for an equivalent number of shares on the same underlying. Here we will focus on selling calls on stocks you already own. This is a very conservative strategy. Conversely, selling naked calls (i.e. selling calls without ownership of the stock) is the most risky option strategy and has unlimited liability. We will therefore only consider the former.
2. Main Benefits.
- Generate income from your existing stock positions
- Reduce risk by giving downside protection to your existing stock holdings
- Forces you to sell high
- Puts the odds in your favor (around 80% of options expire worthless)
3. Possible outcomes.
Whatever happens, you will keep the premium pocketed when the call was sold. Let’s have a look at the mechanics of selling calls through an example. We will assume that you own 100 shares of Lowe ‘s Companies (LOW), that close up 1.53% at $27.87 on August 17, 2012. LOW currently has a P/E of 16.8, which makes it on the strong side of fair valuation and even slightly overvalued. You feel that it may still has room on the upside but would be more comfortable having some downside protection in case the stock pulls back over the next month, and therefore decide to sell one January 2013 call with a strike price of 30 (i.e. 7.6% above the current price) at a premium of $0.80 per share. One call controls 100 shares, so as the seller you would receive $80. From here, there are two main possible outcomes:
- The stock price stays below $30 until expiration of the option. The call you sold expires worthless and you keep the $80 premium received when you initiated the trade. This increases your yield by 2.87% in only 5 months ($80 premium divided by the $2787 current value of your LOW holdings). This equals to an 6.9% annualized return if the stock does not move at all, almost 3 times the current dividend yield of LOW. If the stock goes down, you can see that the premium collected reduces your cost basis by $0.8 per share, providing you with a 2.87% downside protection.
- The stock price rises sufficiently above $30 for the call to be exercised. In this case, you would be forced to sell your 100 shares of LOW at $30 even if it trades at $32. But you already own these shares, so in this case the return of the strategy is maximised: you keep the $80 call premium AND you make $213 on the stock price appreciation, for a total profit of $293 or 10.5% in 5 months (25.2% annualized). That’s without counting the dividend that you would collect in the meantime.
4. Position Management.
The downside is that you may be forced to sell a stock that you would have liked to continue holding. But there are two important things to underscore here:
- If you get exercised and sell your shares, you sell them in this case after a strong run up (LOW hit a low around $24.60 early this month). The stock is more likely than not to pullback and you would still be able to buy back the shares at a lower price later. Note that LOW is currently overbought, which put the odds on your side.
- When the price gets closer to the $30 strile price, you could still roll your position forward and up, which means buying back the call and sell another one with a farther maturty and higher strike price. In many instances, you will be able to do that for a net profit, the time-value of the longer maturity call offsetting the loss on the roll up in strike prices.
