The covered call is among the most attractive of conservative option strategies. It provides an impressive rate of return when properly structured, and it does not increase the most common forms of risk. In fact, market risk—your exposure to lost value in your stock—is reduced with the covered call strategy.
In this chapter, the conservative possibilities of covered calls are explained, starting with the underlying premise necessary to succeed with this strategy. Various outcome scenarios help you form realistic judgments about whether the covered call strategy makes sense.
The Covered Call Concept
No strategy is completely risk-free, not even owning stock in well-managed, strongly capitalized companies. But in the case of a covered call, you seek to enhance profits without incurring added market risk, and the advantage is both practical and inevitable. For many investors, the lost opportunity risk is worth the additional income that covered call strategies generate. (Lost opportunity risk is discussed later in this chapter.)
A covered call strategy has two elements. First is the ownership of 100 shares of stock for each option to be covered; second is the short position in the call option. If you own 100 shares, you sell one call to achieve the one-to-one “covered” status. The call grants the right to the buyer on the other side of the transaction to buy your 100 shares (to call them away) at the set strike price at any time from the date of sale until expiration. If the current price of stock is below the strike price, the call will not be exercised.
Who Makes the Decision?
When you enter a covered call position, you sell the call against stock you own. This means you give the right to exercise to the buyer, and that decision is entirely in the buyer’s hands. You can keep the cash you receive upon selling the short call, whether the call is exercised, closed, or simply expires. You also continue to receive dividends during the period you are short on the call. The big question comes down to this: Is it worthwhile to risk having 100 shares of stock called away if the stock’s price moves above the call’s strike?
The covered calls produce instant cash. You are paid for selling the call. For example, if you can achieve an immediate 10 percent return on your stock by selling a call, is it worthwhile? The answer, of course, depends on your original purchase prices versus today’s stock value as well as the call’s strike.
The disadvantage to selling covered calls is that, first, you tie up 100 shares for each call sold, and you cannot escape from the covered position without closing out that short call. Second, your maximum profit is always limited to the premium received for the call.
You should close the position under one of two circumstances. First, if the value of the short call has declined since the position was opened, you can pay the current price and close at a profit. Second, you may close if the value of stock has moved upward beyond the strike. In this situation, you face the possibility of exercise, which can happen at any time when the call is in the money. When the stock’s price moves above the strike, the net premium value of the short call may be lower than it was when you sold it. This is true because the call’s time value declines as the exercise date draws near. In this situation, it is prudent to buy and avoid exercise while still realizing a net gain on the call transaction. Incidentally, once you close out the covered call position, you are free to repeat the trade, using calls with higher strike prices and later expiration dates.
If the stock’s price moves above strike price so that your short call is ITM, the call’s value may also have increased. You can still avoid exercise without taking a net loss using a technique called rolling (replacement of one call with another). This strategy is explained in detail later in this chapter.
Examples: Three Stocks and Covered Calls
To illustrate how the basic covered call strategy works, examine the three companies in the model portfolio, sharing three common attributes:
- Both listed options and LEAPS are available on the stocks.
- All these stocks are assumed to have current market value above the original basis.
- All stocks show current moderate price volatility levels.
These stocks’ basic attributes are summarized in Table 6.1.
Table 6.1 Sample stocks for covered calls
|
Name of company |
Symbol |
Current Price ($)* |
Dividend Yield (%) |
|
AT&T |
T |
30.34 |
6.64 |
|
Southern Co. |
SO |
52.44 |
4.66 |
|
Altria |
MO |
51.41 |
5.95 |
*As of April 25, 2019. Source: Charles Schwab & Co.
The next step is to analyze a series of options in comparative form. If you compare options with different expiration terms, you should annualize those returns. A summary of call option values expiring in 57 days is shown in Table 6.2.
Table 6.2 Covered call premium, 57 days to expiration
|
Name of company |
Symbol |
Current Price ($)* |
57-day strike |
Call bid premium |
Yield (%)** |
|
AT&T |
T |
30.34 |
30.50 |
1.02 |
3.34 |
|
Southern Co. |
SO |
52.44 |
52.50 |
0.94 |
1.79 |
|
Altria |
MO |
51,41 |
52.50 |
1.29 |
2.46 |
* As of April 25, 2019. Source: Charles Schwab & Co.
** Premium divided by strike.
This table shows a comparative yield. Time to expiration is identical for all three companies; and the strike selected is closest to the current price of stock.
Smart Conservative Ground Rules
All strategies have positive and negative aspects. The covered call strategy is conservative if you understand the transaction’s specific attributes and that you are sure the numbers work in your favor. Following are a few basic ground rules as you proceed through the analysis to ensure a truly conservative application of the covered call strategy:
- Your original purchase price must justify the strategy. The most conservative use of covered calls exists when you own stock that has appreciated in value. The lower your basis in comparison with today’s market value of stock, the more flexibility you have in devising a conservative options strategy.
- The premium value you receive must provide enough yield to justify the covered call exposure. If you plan to use your stock as cover for a short option position, you must be able to justify it in terms of profit levels. If you own shares of many different stocks, you will naturally seek out those option positions that yield the best returns.
- You are willing to accept exercise as one of the possible outcomes. In every covered call position, you must accept the possibility that your 100 shares of stock will be called away. If you do not want exercise under any circumstances, you should not write covered calls.
- The primary risk to the covered call strategy is possible loss of future market gains if stock prices exceed the call’s strike price. This lost opportunity risk should be understood before you enter any covered call strategy.
- The covered call strategy commits capital invested in stock for as long as the short call remains open. Since a conservative strategy requires that your long stock position is maintained as an offset to the short call, your shares are committed until the short position is closed. You escape this commitment when you buy to close the call, when the call is exercised, or when the call expires.
- Most important of all, your primary portfolio strategy must remain the same, seeking long-term investment in the stock of properly selected companies, not in selecting stocks based only on potential covered call returns. One danger in using options to enhance profits is that it could change your entire investment strategy. As a conservative investor, your first rule should be that, no matter what, the proper selection of companies based on fundamental strength and growth prospects must remain the primary means of stock selection and the primary deciding factor for any decision to buy, hold, or sell shares.
A Conservative Approach
Proceeding from the ground rules for covered call writing, the next step is to determine exactly what makes elements of the strategy advantageous. As a conservative investor, what are the primary attributes you need to enter a profitable conservative strategy? There are three: appreciated value in the stock, time and extrinsic value premium, and downside protection.
Element 1: Appreciated Value in the Stock
If the current value is higher than your basis, you have great profit flexibility in entering a covered call strategy. In other words, with those paper profits, you can build in a greater certainty of profits.
Example: Covered Calls without Substantial Appreciated Value in the Stock
You purchased 1,400 shares of AT&T stock at $28 per share; today, shares are worth $30.34. You sell 14 of the 85-day 30-strike call and receive a premium of 114, or $1,596 for 14 contracts (assuming a typical trading fee of $15, assume the net received was $1,581). If exercised, total return on stock and option transactions (without adjusting for annualization or taxes) would be:
Capital gain = 30 strike, 1,400 shares, $42,476 less $28 per share basis = $39,200
Net capital gain = $3,276
Capital gain yield = $3,276 ÷ $39,200 = 8.36% (before annualizing)
Option premium = $1,581
Option return (premium divided by strike) = $1,581 ÷ $30,000
= 5.27%
To accurately annualize the overall yield, option outcome should be separated from capital gains on stock. Why? Based on both holding period and dollar value of the gain, side-by-side comparisons will be distorted. In this example, there are two separate yields, one each from capital gains and options. This is even further complicated by the holding period of stock and by the timing of exercise of the covered call. Finally, the number of quarterly dividends earning during the holding period make it even more difficult to arrive at a valid annualized return, especially when comparing one outcome to another.
Element 2: Time and Extrinsic Value Premium
The key to successful covered call writing is in the time value premium. If the call is ATM or OTM, there is no intrinsic value. Time works for the seller and against the buyer. Buying options can be highly speculative because the buyer must hope not only that the stock rises enough to create intrinsic value prior to expiration but also that the growth in price rises far enough to offset lost time value. Since time value evaporates as expiration approaches, it is difficult to achieve.
Time and extrinsic values from the seller’s point of view are the advantage. Knowing that time value declines no matter how the stock’s price moves by expiration, the time value premium is a cushion, made even more generous when extrinsic value is high.
Element 3: Downside Protection
Every investor whose stock has appreciated in value worries about losing paper profits, so profit-taking is more likely as paper profits increase. Well-disciplined conservative strategy tells you that you should not give in to the temptation to speculate on short-term price movements, that is, by taking profits. However, as the adage tells you, “Wall Street climbs a wall of worry.”
Selling covered calls against appreciated stocks is one way to offset your personal wall of worry. The premium you receive from selling covered calls is, in a sense, a way of taking profits without giving up ownership of shares. Those profits are yours to keep in the event of expiration or exercise, and if you close the position by buying the short call the difference between sell and buy price represents profit or loss.
The net premium you earn from selling calls can be viewed in another way: as downside protection. Viewing covered calls in this way, you achieve a broader range of profit margin, meaning more downside protection. The more premium you receive from selling calls over time, the greater your downside protection.
Tax Ramifications of Covered Calls
Calculating returns without figuring out the after-tax outcome is not realistic. Not only must you consider a tax liability, you need to be aware that the tax rules can drastically affect your tax rate on capital gains. The current rules for federal taxes on option trades are more complex than for most forms of investing. For conservative investors, a crucial point to remember is that selling OTM calls is the least complicated strategy for two reasons. First, the entire premium consists of time and extrinsic values. Second, the tax rules are simple if you restrict your trades to OTM positions, so there is no effect on the calculation of short-term or long-term capital gains holding periods. However, once you sell an ITM call, the whole question becomes much more complicated. Here is a rundown of the tax rules governing options:
- Rules for option buyers. If you buy options, the profit or loss can either be long term or short term depending on how long you own the long option. The net amount is reported on federal tax Schedule D (Capital Gains and Losses) in the year of sale. If the transaction is completed within one year or less, it is taxed as a short-term capital gain or loss. If the total holding period was longer than one year, it is treated as a long-term gain or loss.
- Rules for option sellers. The rules for option sellers are different than for other types of investments. The payment you receive at the time of sale is not taxed at that point. The tax “event” occurs when the position is closed, expired, or exercised. If you sell an option in one year and it is closed in the next, the tax is not calculated until the latter year.
One important exception to the general rule governing short-term and long-term tax rates is that if you keep a short call until expiration, it is treated as a short-term gain or loss, no matter how long the position was open. For example, you may sell a covered LEAPS call that does not expire for 30 months. Upon expiration, the gain is considered short term. If you close out the position with a buy order prior to expiration, it is treated as short term if it was open for one year or less or as long term if the holding period was open more than a year.
If the call is exercised and your stock is called away, the gain is figured including the premium you received from sale of the call and the gain on stock. For example, if your capital gain was $2,400 and you received $830 for the option, all the gain—$3,230—is treated in the same manner. This treatment depends on the holding period of the stock and whether the call is defined under IRS rules as a “qualified” covered call.
Nonqualified covered calls affect the calculation of the long-term gain holding period. If the option you sell is ATM or OTM, the holding period for your stock is not affected or stopped. If the call is ITM and it meets the definition of qualified, the holding period is not changed. If the call is nonqualified, however, the holding period counting toward long-term gain treatment is done away with and, for the purposes of calculating gain, the time limit begins anew once the call position has been closed.
Example: You own stock currently valued at $75 per share. You sell a covered call ITM (below the current value of the stock). In this case, the status of long-term or short-term gain is determined by the rules for qualification for the call. If the call is defined as unqualified, the holding period of stock is suspended and the call position is open. Your stock’s holding period is eliminated entirely and starts over once the call is closed. The time limit stops running if the call remains open.
Six Levels of Separation (of Your Money) for Taxes
The following applies only to ITM covered calls. There are six separate levels of calculation:
- The previous day’s closing stock price is $25 or less, and the option has more than 30 days to go until expiration.
- The previous day’s closing stock price is between $25.01 and $60.00, and the option has more than 30 days until expiration.
- The previous day’s closing stock price is between $60.01 and $150, and the option expires in 31 to 90 days.
- The previous day’s closing stock price is between $60.01 and $150, and the option expires beyond 90 days.
- The previous day’s closing stock price is greater than $150 per share, and the option will expire between 31 and 90 days.
- The previous day’s closing stock price is greater than $150 per share, and the option expires beyond 90 days.
The conservative investor should seek OTM covered calls exclusively. This simplifies the tax calculations and conforms to the commonsense standards defining a conservative strategy. One exception to this general rule is if you have large carryover losses, you may not be concerned with taxation of current-year capital gains. Since annual capital losses are limited to $3,000 maximum, a large carryover loss may be used to absorb current-year gains. So, even if you lose long-term capital gains status for exercised stock, this large carryover loss presents a planning advantage; you can engage in ITM covered call writing without worrying about long-term or short-term restrictions.
Rolling Forward and Up: Exercise Avoidance
You can avoid the complexities of the tax rules by utilizing only OTM covered calls. For conservative investors, this makes sense even without considering how federal taxes affect the strategy. It affects planning if you intend to create a forced sale using deep ITM calls (“deep” means more than 5 points below strike price). Under the definitions in the tax rules, it would convert all stock sales to short term because the options would be nonqualified.
Rather than seeking forced exercise, most conservative investors prefer to keep ownership of the stock and use options to maximize short-term income, hopefully in a repetitive fashion. Exercise avoidance is a far more attractive strategy for most people.
Since covered call writers must accept the possibility of exercise, why avoid it? Although exercise is a possibility, it is often preferable to keep well-selected stocks in the portfolio and to take steps to (a) avoid having it called away, (b) be able to continue writing subsequent calls, and (c) in the event of exercise, maximize income from the transaction. All this requires employing a rolling technique.
Types of Rolls
In a roll, you buy to close a current open position while you sell to open a subsequent position that has one of three possible attributes:
- A roll forward. The new covered call expires later than the old covered call but at the same strike price. Caution: If the stock price moves above this strike price, you risk converting your OTM covered call into an ITM call, so the tax picture of stock profits changes.
- A roll up. The new covered call expires at the same time but at a higher strike price. With this strategy, expiration remains the same, but you “buy” another 5 points of profit in the event of exercise. The difference of 5 points may be only 2 or 3 points of net cost, so if you expect the stock’s price to continue rising, losing a few points in the exchange of one option for another is not negative in every instance. The net difference in buying out of the current position and opening the new one is 2 points, but you gain 5 points in the higher strike price, while converting your ITM short call to a new, OTM short call.
- A roll forward and up. The new covered call expires later than the old covered call and at a higher strike price. This is the most desirable rolling method. It is possible to execute a forward-and-up roll while still producing a net credit. It means more premium income as well as a higher potential exercise price. By avoiding exercise, you gain more net income, and you also gain 5 points in strike.
The Exercise Acceptance Strategy
A final idea is the exercise acceptance strategy. Most conservative investors are content to keep their long-term stocks and to use well-selected OTM calls to create additional profits along with downside protection. However, what if you would be happy to see your call exercised?
Selling covered calls is a profitable alternative to simply owning stock. You can also force exercise by intentionally writing ITM calls. However, since this ensures the loss of long-term status of capital gains when exercise occurs, the strategy must be studied on an after-tax basis. When you have a large carryover loss from previous years, it could be an effective way to create large option premium gains and absorb unused carryover. Your annual net loss deduction is limited to $3,000, but if you have a $30,000 carryover it would take 10 years to use it up without future offsetting capital gains. It is desirable to absorb that loss as soon as possible; in this case, creating a large gain in stock and options by writing deep ITM covered calls (virtually ensuring exercise) would be beneficial because the loss of long-term status is sheltered by the carryover loss.
Limiting Yourself to Conservative Strategies
You probably consider covered calls a conservative strategy because no increased market risk is involved. The alternative, simply owning shares of stock, has an inherent market risk, and discounting the basis by generating call premium reduces the basis in stock which also lowers the net market risk. Covered call writing involves lost opportunity risk; in reviewing likely scenarios for several stocks, you know that such lost opportunities occur in a minority of cases, while consistent high returns from covered calls are certain.
In the next chapter, interesting ways to use options as an alternative to the purchase of shares of stock are explored. The iron butterfly is a hedging strategy, and this can be expanded to create a matrix of hedging over three or more expiration dates.
Class questions for discussion and/or mini-case studies
- The covered call contains two elements:
a. A short call and a long put.
b. A long call and a short put.
c. A call and a put, both short.
d. A short call matched to 100 shares of stock.
- Common attributes of viable covered call candidates include:
a. Availability of options on the underlying.
b. Current market value of the underlying above net basis.
c. Moderate price volatility.
d. All of the above.
- Rolling usually refers to the action of closing a covered call and replacing it with:
a. A covered put.
b. A later-expiring short call below the strike of the original call.
c. A later-expiring call at the same strike or a higher strike.
Discussion
Identify a stock chart appropriate for writing covered calls. Calculate the net basis in stock if shares were purchased today and a covered call written; analyze the potential recovery strategy if share price declined.