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Options III: Strategy for the Long Term - Writing Covered Calls

October 17, 2011 | About:
Chandan Dubey

Chandan Dubey

99 followers
This article is third in series of understanding options. The target audience are long-term value investors. The first and second parts of the series are here.

Options I: Introduction and Pricing

Options II: Strategy for the long term investors - writing puts

In this part we will discuss another strategy in the toolbox of a long-term investor. This is writing calls to increase dividend yield.



What is writing a call?


Remember, from the first part that a call is an instrument which gives the buyer of the call the right but not the obligation to buy the security at the strike price.

For example, let us take a BRK.B call for $80 expiring in January 2013. The buyer of the call has the right to buy the BRK.B security to the seller of the call at the strike price of $80 a security until January 2013. What this means is that the buyer of the call will make money if the price of BRK.B goes above the strike price (ignoring the commission). The higher it goes, the more in-the-money the call is. The price of the stock on the other hand can go both up and down. Let us consider each case and see how it effects the seller of the call (in this case a long term investor)
  • If the price of the stock stays below the strike price, i.e., $80 in this case then the call has no value. What this means is that there is no incentive for the buyer of the call to buy the stock at $80 when he can already buy it in the open market for more than that money. So, the seller of the call keeps the premium he was given when he sold the call and makes a nice profit. Even better, the seller of the call gets this premium when he sold the call and hence is free to invest this money somewhere else, let us say Treasuries, and get an additional yield on it.
  • If the price of the stock goes above the strike price, i.e., above $80 in this case, then the call has value. Let us say the price of BRK.B rises to $85 in February 2012. The higher it goes the worse off the seller of the call is. He might have to sell stocks at $80 a share when they are selling for $85 on the open market. For the long-term investor who bides his time for the market to realize the full potential of his long-term pick, this does not seem like a great deal. Might he not be better off not selling the call and selling the stock when it is substantially overvalued? This is what we aim to discuss in this article.


To be great at writing calls one has to decide on a candidate security first. It is of supreme importance that the security must be selected in a way to suit your needs. Let me give an example for an idea candidate depending on the situation you want yourself to be in.

Scenario I: where this works

Let us suppose that you own a great mega-cap stock. It has nice FCF, good management, nice dividend and a very good stable business with pricing power on its side. This is a business you will like to own for a long time as a core holding. The problem is that the stock seems to be going nowhere. It is down with the market (albeit less down than the general market, has a low beta) and up with the market (again lags the market). You have around 2-3% dividend yield, which is your yearly return. Is this the best you can do? The answer is no. This stock is an ideal candidate to boost your dividend yield by writing calls.

For this example, the best candidate is JNJ. Let us look at the share price graph of JNJ.

1378467723.jpg

JNJ has been range bound between 48 and 70 since Sept. 2003. That is 45% return in seven years if you are really lucky (removing the dividend). If you want to juice more out of the stock which stands at $65 at the moment, you can write a call for say $72 expiring in January 2013. Let us look at the call table

1245952921.jpg

As you see, you can sell a $72.5 call for $1.86 a share. This is an additional 3% yield in a year. You might have to sell JNJ if the stock suddenly takes by more than 12%. This can happen and you might lose your beloved stock. So, it might be advisable to do it on a part of your JNJ holding and also in a way to not totally give up your upside. Note that if $72.5 seems too close a figure, you can write calls for $80 and more.

Scenario II: where it fails

For a hot-shot stock like DNDN which might soar or crash, this strategy is really bad. For a stock like this, ideally you are taking the risk of the zero to really get huge gains if the stock doubles or triples in a short time. This may happen with a small-cap pharma stock with FDA result pending. When you write calls, you take the risk of the downside and trade the chance of upside with the premium you get. In an ideal deal the stock will not move above your strike price and you get to keep the premium and the stock, which has not fallen much from its price. DNDN is not a good candidate for this strategy. If you write a $13 call for say January 2013, you will earn $3 a share (see table, source Businessweek).

1360653049.jpg

The stock is trading at $9.55 and the strike price of 13.5 is almost 30% upside. The problem is that DNDN has a high beta and it may take off on some good news and go to $25 (ideally, this is why you took the risk of buying the stock). Selling a call at strike price of $13 will leave you with only $6 ($3 for the option +$3 for selling at $13 a share) profit, while you could have made $15 in profits (almost 150% instead of 66%).

On the flip-side there is one good thing to note here. If DNDN falls to $6, you have cushioned your downside because of writing the call. Now your average share price for DNDN is $6 a share and you have not lost much. So, your strategy should depend on what you would like to achieve by writing the option.

When to write calls?

  • If you are considering selling a stock by putting a limit order, say Intel (INTC), you bought it at $20 in the last drop (see the stock market drop in August 2011) and you think $26 is a fair price for the stock and want to sell it when INTC hits $25, well you can write a call and get paid until INTC hits the strike price.
  • You want to make the cost basis of the stock lower. Say, you own DNDN at $10, and you think that DNDN is not going to hit $13 soon. You sell a call option at $13 and lower the basis price of the stock to $10-premium.
  • You want to have more yield on a stable mega-cap stock. This was already described above.


Make sure that you are willing to sell the stock if it hits the strike price. Also, make sure that you own the stock.

For most investors, options are an example of what got the stock market into the mess it is in. Options can give you leverage and let you have huge amounts of gains and losses. But some option strategies do not require such adrenaline-fueled attitude. For conservative long-term investors, writing calls (and writing puts) pays you for something you were considering doing anyway.

About the author:

Chandan Dubey
I invest because I want to be free by the time I reach 40 years of age i.e., 2025. My investment style is to find a small number of bets with large margins of safety. I pay a lot of attention to management and their incentive. Ideally, I like to buy owner operator businesses. I am fortunate to have a strong inclination towards studying. I aid my financial understanding by extensive reading in psychology, economic, social sciences etc.

Rating: 4.1/5 (17 votes)

Comments

Adib Motiwala
Adib Motiwala - 3 years ago
Good post again. However I want to pick on a few points for discussion

1) Scenario I : I have myself sold covered calls for JNJ at $65 strike for a year now. I started doing it as I started to get bored with the stock not going anywhere. However, I usually have sold 1-3 month calls on JNJ. So, i can see how it works quite well for a side ways and non volatile stock.

Ofcourse, you have to decide if you want to sell short term calls (few months) or leaps. With leaps, you are letting someone take all the upside for putting up very little capital and you give him 12-15 months or more for the stock to appreciate. I have rarely sold such long dated calls. Over time, each person figures out what kinds of calls to sell on the underlying or if they are even worth it.

2) Scenario II : this one is interesting. Firstly, in the above case you were betting on the side ways nature of the stock if you sold calls at the money or without much upside. Most times, you should be selling calls at 80-90% of your target price so that the premium helps you get closer to your desired sell price ( Strike + Premium). If the underlying stock is a volatile one, you may be in a position where the stock rises but crashes before expiration. In that case, the premium will be yours but you lost a chance to exit from the stock at a good price. This happens a lot. One way out would be to sell calls on partial position. Say 2 calls out of 400 shares. That way you are free to sell 200 shares in the market as the stock appreciates. Now, if you don't mind holding the stock in case it crashes, then you may want to sell calls on the entire position. It just depends. If the underlying stock is volatile, then you will get much better premiums than on stocks like JNJ WMT etc.

Just my 2 cents

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