The covered call is typically considered a conservative option. However, writing one correctly can be complicated. Here’s a brief summary of what a covered call is, followed by nine tips for writing and handling one wisely.
What is a Covered Call?
A covered call is when a stockholder sells an option—for a premium that he keeps no matter what the outcome. This option is to buy a hundred or more shares from him of a certain stock, at a certain price (known as the strike price), within a certain time frame.
It is the stockholder’s hope that the price of the stock does not reach or exceed the strike price before the contract expires, as the buyer will generally then let the contract go and the stockholder will pocket the premium and keep the shares. It is the buyer’s hope that the price does go over the strike price, and that he or she can exercise their option to buy the stock at below-market prices.
In essence, a covered call is a form of a investment between a seller and a buyer which is ultimately decided by the stock market itself.
While Simple in Theory, a Covered Call Can Get Complicated in Execution
There are certain risks, as the graph above illustrates. If the stock you choose to write a covered call for goes through the roof, you will be obligated to sell at a much lower price than the market would currently have borne. If it drops too far, even the cushion afforded you by the premium will not protect you from completely from loss.
Following are nine tips to follow when handling covered calls:
Tip One: Choose stocks with medium implied volatility
Implied volatility is a fancy way of discussing a stock’s likelihood of changing its price. For covered calls, you preferably want a stock which is in a sweet spot where it’s volatile enough to bring a decent premium but not so volatile that you will win or lose big when it moves.
Many stockholders make use of volatility charts like the example below when making these judgments:
In the above chart, the implied volatility is in gold and the historical volatility is in blue. Remember that implied volatility is by nature a prediction and may turn out to be wrong.
Tip Two: Being called is no reason to panic
Provided the shares belong to the agreed-upon stock, you can offer up any of them that you choose upon being called. You can also choose to purchase new ones from the open market and offer them up instead. This can have an effect on any taxes you will have to pay on capital gains, so consult your tax advisor to be sure which ones are best to offer up.
Tip Three: Have plans for the stock declining
Generally, investors write covered calls for bull stocks, but sometimes these stocks go bear without warning. If your stock drops, you always have the option of buying the call back at a lower price than you sold it for.
If you do this, you will both make a profit on the position and be able to sell off the stock.
Tip Four: Buy-writes may be the way to go
- A buy-write is when you simultaneously write the covered call and buy the stock it is for.
- Buy-writes guarantee that a stock is where you think it is price-wise at the time of the write-up and reduce market risk.
- However, they may complicate fees and taxes, so do your research ahead of time.
Tip Five: Be aware of the value of both “static” and “if-called” returns
A static return on a covered call is when the stock is never called. If-called returns are the opposite, where you are required to sell the stock at the strike price.
Before writing a covered call, it is imperative that you work out the value of both outcomes and make sure you will be happy with either.
Tip Six: Diversify
- Don’t make any position larger than 10% of your portfolio.
- Remember to diversify sectors.
- You may also wish to consider writing covered calls for ETFs instead, as they come pre-diversified.
Tip Seven: Choose stocks with high-yield dividends
Why limit yourself to making money off the covered-call premium? Choose stocks that will pay you for owning them.
Tip Eight: If a Call Has a Really, Really Good Premium, Find Out Why Before You Invest
Like all other things in life and finance, if it sounds too good to be true, it may well be. Look into why the great premium is being offered before you commit to anything.
Tip Nine: You May End Up Owning this Stock
Do you want to own stock that looks like this?
Be careful when you choose stock for a covered call—after all, it may not get called away.
Writing covered calls intelligently takes effort—but is totally worth it when it works. The advice outlined above is a good starting point, and it can never hurt to do your research as well. Learn all you can, consult experts, and you may just find the ability to make money off of stocks that you never thought you could.