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Outperform the Market with Covered Calls

March 27, 2012 | About:
Today’s rock-bottom interest rates and overpriced financial assets have created a low-return investment world that requires proactive yield-enhancement techniques such as covered calls to generate the additional investment rate of return needed to retire comfortably.

Selling covered calls generates additional income and lowers the break-even cost basis of stock you already own, thus reducing the downside risk of stock ownership at all price points.

Unfortunately, many investors are under the mistaken impression that this strategy underperforms in dividend-paying stocksto pay living expenses, getting your stock called away by the exercise of a covered call is only a minor inconvenience — you can always buy the stock back immediately after exercise to continue receiving dividends.

Second, there is a misconception that the moment a stock rises above the strike price of a covered call, the call will be exercised. This is completely untrue. The value of a call option has two components: (1) intrinsic value, which is the value you could get right now by exercising the option; and (2) time value, which is a speculative surcharge based on what the option could be worth if the stock moves higher between now and the option’s expiration date.

Although time value decays and reaches zero at the expiration date, it is greater than zero prior to the expiration date, so an option holder is almost always better off selling a call option — thus receiving both intrinsic value and time value — rather than exercising it and receiving only intrinsic value. Early exercise of a call option is only likely in two scenarios. By recognizing these two scenarios and taking action to eliminate them (i.e., buying back the call and selling a different one), you can reduce the risk of option exercise. The two scenarios are:

(1) The covered call option is deep “in the money” — which means that the underlying stock trades far above the call strike — and the bid price of the call option is below the “intrinsic value” one could get from exercising the call. For example, if a stock trades at $77 and a $70 call option is bid $6.75/$7.25, the call owner would make more money exercising and receiving $7 ($77-$70) than he would selling the call for $6.75.

(2) The covered-call option is “at the money” or “in the money” when an ex-dividend date is near.

In the ex-dividend scenario, a call owner will exercise early if the amount of the dividend exceeds the amount of time value he will forfeit by exercising the call.

For example, if XYZ stock trades at $50 and the $45 call sells for $5.20, the call has $5.00 of intrinsic value ($50-$45) and $0.20 of time value. If an ex-dividend date is tomorrow and the dividend is $0.50 per share, the call owner will exercise early because the $0.50 dividend is greater than the $0.20 of time value forfeited.

However, if the dividend were only $0.10 per share, the call owner wouldn’t exercise because the call option’s time value would be worth more than the dividend amount. (See “Early Exercise is Unlikely.”)

Remember, writing covered calls is not a sell-and-forget strategy, but one that requires monitoring. Given the impressive outperformance covered calls have generated over time, however, the small degree of monitoring that is required is well worth it. For a more detailed guide on options trading, check out my free Options Trading Strategies guide.

About the author:

Jim Fink
Investing Daily provides stock market advice and investment newsletters to help independent investors achieve a secure and rewarding financial future. The site’s coverage focuses on finding the most profitable emerging trends in the investment universe to bring investors pragmatic and in-depth coverage of the names that are taking advantage of these opportunities.

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