Generate dividends for your stocks (Covered Call option writing strategy)
In a previous article, I presented an option strategy - Selling Cash Covered Put Options. This could be used to generate extra income while you wait for the stock to come down to your desired purchase price.
In this article, I present another conservative option strategy that can be used to generate extra income from your existing stock holdings. The strategy is simply to sell a covered call on your stock. Letās first look at what a call option is and then see the strategy in action with an example.
Call option : Wikipedia defines Call Option as āA call option often it is simply labeled a "call", is a financial contract between two parties, the buyer and the seller of this type ofoption.[1]The buyer of the call option has theright, but not the obligationto buy an agreed quantity of a particularcommodityorfinancial instrument(theunderlying) from the seller of the option at a certain time (the expiration date) for a certain price (thestrike price). The seller (or "writer") is obligated to sell the commodity or financial instrument should the buyer so decide. The buyer pays a fee (called a premium) for this right.ā
Why would someone buy a call option: Say I am bullish on a stock say Apple but I do not want to invest a large amount of money in it or I donāt have that money or I just like to use options inherent leverage to juice up my returns. In that case, I could buy call options for Apple instead of buying the stock. When buying options, you look at the strike price and the expiration date. Example: Call options for Apple for the $280 strike price for Jan 2011 closed at $8.8 today. Remember that one option contract means the right to purchase 100 shares. So, your cost to purchase one call is $8.8 * 100 = $880. This money spent is called the option premium. Compare this with the amount of money needed to buy 100 shares. It would be $243 * 100 = $24,300. So, as you can see a small premium ($880) gives you the right over control of the same number of shares of Apple as $24,300.
So, why would you sell a call option? In my Options and Futures Markets class, I learnt that writing call options is one of the most common strategies used by institutional investors. You may have heard that about 70% of options expire worthless or unexercised. So, obviously the āsmartā money is selling options with the objective of collecting the option premium from the buyer.
Letās assume that you have a stock that you bought and are sitting on a large gain. Also, you feel that the stock is close to being fully priced and you donāt mind selling it around current prices. So, you have a few options
(1)Sell the stock right away using a market order
(2)Place a sell limit order above the current market price to capture a bit more of the upside
(3)Sell some shares now and sell some more as the stock moves higher
(4)Sell a call on the underlying shares with strike price at or above the current stock price.
Example:
Say I have bought Apple (AAPL, Financial) at $200. I did not sell when Apple peaked at $280 but I am still sitting pretty on a decent 20% gains (Apple trading around $240). I feel that the stock could hit $280 again by Jan 2011. I decide that I will sell the stock if it does reach that price but not before that. So, I look at the Call options for Apple on Yahoo Finance. I see the $280 trading at $8.8, $290 trading at $6.45 and so on. I decide to sell the $280 call option on Apple. I earn $880 as the option premium. So, in essence my selling price would be $280 + 8.8 = $288.8. If I am fine with selling at $280, this should appeal to me. Selling a call option with a strike price greater than the current stock price is considered an out of the money option.
How does it work?
Ā· If the price of AAPL closes above $280 on the expiration date, then my selling price is capped at $280. I would keep the option premium of $880. The same would happen if you would have placed a limit order but you would not earn the option premium.
Ā· If AAPL closes below $280, then I keep my shares as the option expires worthless. I retain the option premium. The option premium can be considered as a dividend that you generated for your shares ( despite the fact that AAPL does not currently pay a dividend)
Ā· If AAPL shares fall sharply, then the option would expire and I would keep the premium. It is possible that some of my unrealized gains could be reduced. However, you run the same risk with a limit order as well. In this case, the option premium acts as a buffer and reduces some of your losses.
Additional points to consider
Ā· Selling covered call option has limited upside (higher strike price + option premium) and unlimited downside ( stock could go to zero.) Keep that in mind.
Ā· Consider selling option only for stocks that you already own. This is called a Covered Call. The Call that you write is covered by the underlying shares. If you sell an option without owning the underlying security, that is referred to as ānaked callā. Selling of ānakedā call can be extremely risky and should be avoided. If you sell an option and the stock runs up say like a Netflix, then you are liable to buy shares at the higher price to deliver to the owner of the Call or close your position by buying back the call at a much higher price.
Ā· Some investors use a strategy called ābuy-writeā. In this case, the investor buys the shares and immediately sells an option on the shares. In this case, the investor is expecting that the stock either will be called away so he can pocket the premium or the stock will end lower and the option will expire worthless giving him another chance to repeat the call writing. This strategy is used as a regular income generation strategy.
Ā· Another idea is selling at the money call options or deep in the money call options. Example: Selling AAPL call option at strike price $250 for Jan 2011 would fetch you $19.10. So, your effective selling price is $269.10. If the stock prices falls drastically, the option premium will reduce your net buy price to 240-19 = $221. In essence, you are saying I will either own the stock at $221. At higher prices, I rather not own it.
If you sell deep in the money call option, your upside is quite limited. Say you sell the $200 strike option for Jan 2011, your premium will be $50.75 which seems high. But, your effective selling price is only $250.75 ( compared to $288 for out of the money option). This strategy is used mostly by people who do a buy write strategy and want to make sure that the option is exercised and they just collect the premium. However, the return would be relatively small $250-$240 / $240 = 4.2%.
Conclusion: I consider writing covered calls as a smart and disciplined way of earning extra income from the stocks you already own. Investors tend to think that options (or derivatives in general) are risky and value investors have no place for them. I presented an example of one type of option that if used wisely is a good tool to have in the value investorās toolbox.
Disclaimer: I have a long position in AAPL. My positions may change at any time without any further updates. Please conduct your own research before considering investments based on my posts. This post is to be considered as my research and for education purposes only. Please do not take this as advice or a recommendation to buy or sell any of the stocks discussed.
In a previous article, I presented an option strategy - Selling Cash Covered Put Options. This could be used to generate extra income while you wait for the stock to come down to your desired purchase price.
In this article, I present another conservative option strategy that can be used to generate extra income from your existing stock holdings. The strategy is simply to sell a covered call on your stock. Letās first look at what a call option is and then see the strategy in action with an example.
Call option : Wikipedia defines Call Option as āA call option often it is simply labeled a "call", is a financial contract between two parties, the buyer and the seller of this type ofoption.[1]The buyer of the call option has theright, but not the obligationto buy an agreed quantity of a particularcommodityorfinancial instrument(theunderlying) from the seller of the option at a certain time (the expiration date) for a certain price (thestrike price). The seller (or "writer") is obligated to sell the commodity or financial instrument should the buyer so decide. The buyer pays a fee (called a premium) for this right.ā
Why would someone buy a call option: Say I am bullish on a stock say Apple but I do not want to invest a large amount of money in it or I donāt have that money or I just like to use options inherent leverage to juice up my returns. In that case, I could buy call options for Apple instead of buying the stock. When buying options, you look at the strike price and the expiration date. Example: Call options for Apple for the $280 strike price for Jan 2011 closed at $8.8 today. Remember that one option contract means the right to purchase 100 shares. So, your cost to purchase one call is $8.8 * 100 = $880. This money spent is called the option premium. Compare this with the amount of money needed to buy 100 shares. It would be $243 * 100 = $24,300. So, as you can see a small premium ($880) gives you the right over control of the same number of shares of Apple as $24,300.
So, why would you sell a call option? In my Options and Futures Markets class, I learnt that writing call options is one of the most common strategies used by institutional investors. You may have heard that about 70% of options expire worthless or unexercised. So, obviously the āsmartā money is selling options with the objective of collecting the option premium from the buyer.
Letās assume that you have a stock that you bought and are sitting on a large gain. Also, you feel that the stock is close to being fully priced and you donāt mind selling it around current prices. So, you have a few options
(1)Sell the stock right away using a market order
(2)Place a sell limit order above the current market price to capture a bit more of the upside
(3)Sell some shares now and sell some more as the stock moves higher
(4)Sell a call on the underlying shares with strike price at or above the current stock price.
Example:
Say I have bought Apple (AAPL, Financial) at $200. I did not sell when Apple peaked at $280 but I am still sitting pretty on a decent 20% gains (Apple trading around $240). I feel that the stock could hit $280 again by Jan 2011. I decide that I will sell the stock if it does reach that price but not before that. So, I look at the Call options for Apple on Yahoo Finance. I see the $280 trading at $8.8, $290 trading at $6.45 and so on. I decide to sell the $280 call option on Apple. I earn $880 as the option premium. So, in essence my selling price would be $280 + 8.8 = $288.8. If I am fine with selling at $280, this should appeal to me. Selling a call option with a strike price greater than the current stock price is considered an out of the money option.
How does it work?
Ā· If the price of AAPL closes above $280 on the expiration date, then my selling price is capped at $280. I would keep the option premium of $880. The same would happen if you would have placed a limit order but you would not earn the option premium.
Ā· If AAPL closes below $280, then I keep my shares as the option expires worthless. I retain the option premium. The option premium can be considered as a dividend that you generated for your shares ( despite the fact that AAPL does not currently pay a dividend)
Ā· If AAPL shares fall sharply, then the option would expire and I would keep the premium. It is possible that some of my unrealized gains could be reduced. However, you run the same risk with a limit order as well. In this case, the option premium acts as a buffer and reduces some of your losses.
Additional points to consider
Ā· Selling covered call option has limited upside (higher strike price + option premium) and unlimited downside ( stock could go to zero.) Keep that in mind.
Ā· Consider selling option only for stocks that you already own. This is called a Covered Call. The Call that you write is covered by the underlying shares. If you sell an option without owning the underlying security, that is referred to as ānaked callā. Selling of ānakedā call can be extremely risky and should be avoided. If you sell an option and the stock runs up say like a Netflix, then you are liable to buy shares at the higher price to deliver to the owner of the Call or close your position by buying back the call at a much higher price.
Ā· Some investors use a strategy called ābuy-writeā. In this case, the investor buys the shares and immediately sells an option on the shares. In this case, the investor is expecting that the stock either will be called away so he can pocket the premium or the stock will end lower and the option will expire worthless giving him another chance to repeat the call writing. This strategy is used as a regular income generation strategy.
Ā· Another idea is selling at the money call options or deep in the money call options. Example: Selling AAPL call option at strike price $250 for Jan 2011 would fetch you $19.10. So, your effective selling price is $269.10. If the stock prices falls drastically, the option premium will reduce your net buy price to 240-19 = $221. In essence, you are saying I will either own the stock at $221. At higher prices, I rather not own it.
If you sell deep in the money call option, your upside is quite limited. Say you sell the $200 strike option for Jan 2011, your premium will be $50.75 which seems high. But, your effective selling price is only $250.75 ( compared to $288 for out of the money option). This strategy is used mostly by people who do a buy write strategy and want to make sure that the option is exercised and they just collect the premium. However, the return would be relatively small $250-$240 / $240 = 4.2%.
Conclusion: I consider writing covered calls as a smart and disciplined way of earning extra income from the stocks you already own. Investors tend to think that options (or derivatives in general) are risky and value investors have no place for them. I presented an example of one type of option that if used wisely is a good tool to have in the value investorās toolbox.
Disclaimer: I have a long position in AAPL. My positions may change at any time without any further updates. Please conduct your own research before considering investments based on my posts. This post is to be considered as my research and for education purposes only. Please do not take this as advice or a recommendation to buy or sell any of the stocks discussed.
