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Many investors probably wish they had sold some stock before the current market downturn.
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Volatile stock prices are propelling the humble covered call strategy to the forefront of the options market.
The strategy involves selling a call option with a strike price higher than the price of the underlying stock, and which typically expires in less than three months. It is well suited for investors looking for ways to manage long-term stock positions that are suddenly facing bullish resistance. (Call options give the buyer the right to buy an underlying asset at a set price and time.)
Selling call options on stocks that an investor owns (hence “hedged”) can enhance returns, and the proceeds received from selling the call can even modestly cover the position by the amount of money received for the call. . That income can add up for investors who consistently use the strategy as a potential source of additional return for their stocks. Think of it as something akin to collecting rent, especially on stocks with stagnant prices.
The covered call strategy is often misunderstood. Many investors mistakenly believe that the strategy limits the potential gain from owning shares at the call strike price. If the share price rises to the call strike price, or beyond, they believe they are stuck selling shares at the strike price.
The reality is different. While call and put options on individual stocks and exchange-traded funds can technically be exercised at any time, they are infrequently exercised well in advance of expiration, even when stock prices exceed the purchase strike price. Why? The person on the other side of the transaction is usually looking to avoid paying a “time premium” to buy the call. Instead, the call option is likely to be exercised at or near the expiration date, when option prices tend to mirror the stock price without any fear or greed premium.
There is one exception: If an expiration cycle covers when a company pays a dividend, investors should be careful. Dividend payments attract predatory traders who exercise options early to collect those payments.
Ideally, the stock price remains below the call strike price at expiration. In that case, the money received for the call is saved. But if the stock price rises above the strike price before expiration, it gets interesting.
Investors can handle this in two key ways. They can sell some shares, hedge the calls, and reset the trade at a higher strike price that reflects the new trading range for the shares. Everyone complains about selling shares and incurring taxes, but selling shares to cover the cost of buying back a call can be a disciplined way to book profits. Many investors probably wish they had sold some stock before the current market downturn.
Calls can also be “rolled over” to a later due date. The idea that shooting or adjusting positions is expensive is also not entirely true. Investors can write options at strike prices that are lower than the stock price, essentially injecting the option with a time premium to make it less attractive for someone to exercise the contract early. By jumping from year to year and expiration to expiration, investors can often continue to generate income, while buying time for the share price to normalize.
There is never a free lunch when it comes to markets and investments, but stop thinking that a covered call strategy cannot be split. Once a call option on a stock is sold, investors should view the stock and the call as related entities that can, if necessary, be managed individually. Anyone who remembers that fact will never look at the humble deck call strategy the same way.
Trading is a blend of art and science that is tempered by discipline and experience. Successful investors know when it pays to be a fox or a wolf.
Steven M. Sears is president and chief operating officer of Options Solutions, a specialty asset management firm. Neither he nor the company has a position in the options or underlying securities mentioned in this column.
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