A guest post by Christian Amsberry.
You may have heard the terms “selling covered calls” or “covered call writing.” This strategy allows someone who owns stock to sell someone else the right to buy the stock at a predetermined price on or before a predetermined date. This right to buy is commonly known as a “call option.” The seller of a call option receives a cash payment (premium) from the buyer. The buyer pays the premium in exchange for the right to purchase the stock according to the terms of the option. Call options are usually sold in 100 unit lots. In other words, one call option contract consists of the right to buy 100 shares of stock. When you sell call options, you (as the seller) must choose a predetermined sale price for the stock (strike price) and a date when the options will expire (expiration date). How much premium you receive will depend on the strike price, expiration date, and other factors. Typically, the longer the option period and the lower the strike price, the more a buyer is willing to pay.
Example: Selling Covered Calls on Chevron Stock (CVX)
Jim Smith has retired from Chevron and has 3,000 shares of Chevron’s common stock in his IRA. Jim likes Chevron, but is willing to sell some of his shares at $115. Chevron stock is currently trading at $105 per share and Jim doesn’t think it will go above $115 within the next six months. Being that Chevron stock is traded by many investors, it will be subject to different opinions. As such, it is likely that another investor believes Chevron stock will go above $115 within the next six months. In such a situation, Jim can sell 1,000 Chevron call options (10 contracts) to another party that wants the right to purchase Chevron stock at $115. The buyer will need to pay a premium, say $2 per share, for the right to buy the stock at $115 anytime during the next six months. Jim sells the options and collects $2,000 in premium (1,000 shares x $2 per share) from the buyer immediately. Over the next six months, Chevron’s stock price stays below $115 per share and ends up back at $105. The buyer of the options will not exercise the right to purchase Chevron at $115 (because it is only trading at $105) and will instead let the options “expire worthless.” Meanwhile, Jim made $2,000 that he would not have made if he did not sell the options. Since Jim did not sell his shares of Chevron stock, he was also able to collect any dividends that were paid during the option period. After the options expire, Jim can sell more calls against the 1,000 shares that were previously under contract.
What happens if Chevron’s stock price goes above $115 during the six month option period?
Jim will most likely have to sell 1,000 shares of Chevron at $115 per share. Even if Chevron is at $200, once the options are exercised, Jim must sell the 1,000 shares at the agreed-upon strike price of $115. Since Jim was paid $2 per share when he sold the covered calls he essentially sells the stock at $117 per share.
What are the worst and best case scenarios for selling covered calls?
The best case is for the stock price to never go above the option’s strike price, but to expire as close below the strike price as possible. In this case, you (as the seller) will keep your stock, potentially get some price appreciation, and also pocket the premiums that you were paid when you sold the options. The worst case is for the stock price to end up significantly above the option’s strike price. In this case, you will be forced to sell your stock at the option’s strike price and give up any additional gains (however you will still keep the premium you received).
When do covered calls make sense?
Let’s face it; feelings and psychology can really influence investor behavior. Emotions can prevent investors from making rational financial decisions. For example, someone who is emotionally tied to stock may be unwilling to sell it, even if the stock constitutes a large concentrated position that is too risky to justify. Using covered calls in this situation may be a good way to remove emotion from a logical decision to sell. Being able to choose a predetermined price to sell at may be like parting on your own terms, and help mitigate feelings of separation anxiety.
Covered calls can also work when you don’t expect the stock you own to move substantially in price. By selling covered calls, the premiums you receive can offset small declines in price, and improve returns in flat market conditions. Another instance where covered calls could make sense is when an investor needs to generate income instead of capital appreciation. Particularly now, with current interest rates so low and fixed income investors starved for yield, a covered call writing strategy can be used to supplement investment income.
While we used Chevron as an example here, we can apply the same strategy to many public stocks, ETFs, and other exchange-traded products. Regardless of the situation, investors should consult with their professional advisors to determine if covered call writing is appropriate for their circumstances.
The BCM Team
This blog is for informational purposes only. Nothing on this blog constitutes investment, tax, or legal advice. You should conduct proper due diligence and / or consult with professional advisers before taking any investment action.