INVESTING

What’s A Covered Call (And Why Would I Care)?

A simple way to get the cash flow you want from the stocks you have.

Erik Bassett

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Photo by Michael Longmire on Unsplash

I like dividends. A lot.

And odds are you do, too.

It’s a beautiful thing to collect “thank-you” checks just for believing in a business. That’s about as passive as it gets.

The thing is, really passive income usually means really low returns…at least at first. Sure, they’ll snowball into something massive over a few decades, but that’s a long time.

You might want to cover your bills, your rent/mortgage, even your entire lifestyle with dividends long before you’re old(er) and gray(er).

You know, enjoy the cash flow while you’re still young enough to. Now there’s a novel idea!

For years, I thought the only way to expedite the process was to take on riskier and riskier investments. And there’s no harm in doing that with a tiny piece of your portfolio — an amount that wouldn’t really hurt to lose — but speaking as a husband and father, making huge bets with serious downside is out of the question.

Besides, even growth stocks have flat spells. Solid, undervalued businesses may go nowhere for months. I wanted to coax at least some returns out of them, if only to reinvest while prices remain low.

So I figured I was back to square one: blue-chip dividend stocks and a few lucky growth and value plays. They’re hard to go wrong with, on average, but they take their sweet time to cover even a frugal lifestyle. Again, taking on a bunch of risk was simply not an option.

But then I learned about something that significantly changed my financial outlook: covered calls.

Or, as I’ve come to call it, a DIY dividend.

It’s a beautifully simple and beautifully boring method.

  1. Pick a stock that you have (or will buy) at least 100 shares of.
  2. Sell an out-of-the-money call option against those shares.
  3. Decide whether to let the contract expire, roll it, or accept assignment.
  4. Repeat 1–3 ad infinitum, and spend or reinvest the profits as you go.

If that was all Greek to you, then don’t worry. By the end of this two-part guide, you’ll understand each of those steps in detail — along with a heap of tips I’ve learned through months of research followed by plenty of trial and error.

I’m not a financial professional. This is purely opinion and entertainment, not advice. Do what’s right for you, and if in doubt about what that is, then it’s important to find someone who’s legally able to tell you.

I’m assuming you’ve traded stocks in a brokerage account before, and you’re familiar with at least basic market terminology and concepts. You’ll also need 100 shares of an optionable stock/ETF to “play along.” Not all assets are good candidates, though, so I’ll cover selection in part two. (Again, not financial advice).

This will all be a lot easier if you’re familiar with basic options concepts. I’ll keep jargon to a minimum, but if that’s totally new territory, then start with the following intro and save this article for later.

Anyway, here’s the gist of it.

The general principles

Bob writes a call option contract. Joan buys the contract from Bob by paying him a cash premium.

The contract gives Joan the right to buy 100 shares of Bob’s stock (the underlying) at a predetermined price (the strike price) on or before a predetermined date (the expiration date).

Joan doesn’t have to exercise that right, but if she chooses to, then Bob is obligated (assigned) to sell her those 100 shares at the strike price.

In effect, Bob has sold Joan his rights to any upside his stock might have beyond the strike price.

That might be a strange concept, so let’s pause for a second.

As a shareholder, Bob had unlimited upside. Whether the stock rises by one buck or one hundred, it was all his.

But as a covered-call seller, his upside is limited to the difference between the strike price and the average cost of his shares. As compensation for giving up that upside, he received guaranteed cash flow in the form of the premium.

Conversely, Joan gets the right to that unlimited upside…but only upwards of the strike price.

This particular strike price is possible but unlikely for the stock to reach. It satisfies Joan’s desire for a small, manageable bet, and it satisfied Bob’s desire for a little cash and high likelihood of retaining his shares.

What’s the point?

You might reasonably wonder why anyone would want in on this deal.

As for Joan, she pays a premium up front for the right to buy the stock (the underlying assets) at what could turn out to be a bargain. If the stock goes to the moon, then she’s got a great deal. If it doesn’t, well, she’s only lost the premium and no more.

As for Bob, he gets to keep that premium no matter what happens. If the stock crosses the strike price, then Joan will exercise it and Bob has to sell.

If it does not, then Joan won’t exercise it, so the call option ends up worthless after expiration day. He’s also free to sell another one after that, and after that…

Better still, as long as Bob only writes a call whose strike price is above his average cost of the underlying shares, then he cannot be forced to sell at a loss. Of course, there’s still the inherent risk from owning stock in the first place, but it’s mitigated by the call premium he receives.

In a nutshell, he’s selling Joan the rights to the upside (in excess of the strike price) on his shares. And since he already owns those shares, they serve as collateral to “cover” the contract. Thus, a covered call.

Some real(istic) numbers

Let’s fill in some imaginary but plausible numbers to tie this together.

Bob owns 100 shares of a steady, rather boring blue-chip called XYZ Company. Its market price is $40/share, but Bob bought his shares a couple years ago at an average of just $30 (his cost basis).

Bob’s also pretty sure that the stock won’t exceed $45/share in the next 30 days. If it did, he’d be perfectly content to sell it at $45 any time between now and then. Considering he only paid $30 in the first place, it would be a 50% return in just a couple years.

He likes collecting the 5% annual dividend yield, but he wants more cash flow to help offset living expenses.

Joan, on the other hand, thinks there’s a small but real chance XYZ will trade above $45 within the next 30 days, and probably much higher than that. She’s not positive, so she doesn’t want to buy it right now. Still, she’s happy to pay a little cash today for the right to buy it at precisely $45 in the next 30 days.

Setting up the trade

XYZ is widely traded, so Bob and Joan both go to their brokerage’s website, pull up XYZ, and look at the options chain. They see a premium of $0.75 for a $45 XYZ call option expiring in 30 days.

Remember, one options contract controls 100 shares of the underlying stock or ETF, so you’d multiply that $0.75 premium by 100 to get $75. That would be the actual debit/credit to their brokerage accounts for buying/selling the contract.

Anyway, they both think $75 is reasonable.

Joan is willing to risk $75 for the right to buy XYZ at $45/share if it ends up even higher within 30 days. The odds are against her, but there’s always a chance she’ll get Bob’s shares for a great price.

Bob, for his part, consider $75 fair compensation for committing to sell XYZ at $45/share (if and only if Joan actually exercises the contract). The odds are in his favor, so he’ll probably retain his shares. Either way, it’s a guaranteed $75 in his pocket, which is a respectable 2.5% return on his original 100 shares (at $30 each) in just 30 days.

So, after they both run the numbers, Bob enters his sell-to-open (short) order, Joan enters her buy-to-open (long), and through the magic of the internet, they immediately have a deal.

How does it end?

Let’s recap the deal:

  • Bob wrote Joan a promise to sell 100 shares of XYZ for $45 on (or before) 30 days from now.
  • If XYZ exceeds $45, then no matter the market price at that time, she can exercise her option and buy Bob’s shares for precisely $45.
  • If XYZ doesn’t reach $45 before expiration, then she wouldn’t want to exercise it, so Bob would keep his shares.

Based on that information, how much does each of them stand to make?

Scenario 1: XYZ is below $45 at expiration

First, let’s assume XYZ is somewhere below $45 when the call option expires. We’ll arbitrarily say it’s $42.

In that case, Joan doesn’t have any reason to exercise the call with a $45 strike when she could buy shares on the market for $42 and save $3/share. She has still lost the premium of $75, but that’s it.

Likewise, Bob keeps his shares and he keeps the $75 premium that Joan paid.

Now that the contract has expired, his collateral (shares) are released, and he’s free to write another, new call options and collect more premium…if he wants to.

Scenario 2: XYZ is above $45 at expiration

Let’s assume XYZ does rise above the strike price to $48/share on expiration day. It could potentially be anything, but we’ll just use that as a concrete number.

In that case, Joan exercises the call and pays $45/share (as well as the $0.75/share in option premium she already paid up front). That’s $45.75/share in total, which is $2.25/share less than the market price of $48. With the options contract multiplier of 100 shares, she’s $225 better off than if she’d just bought at the market price.

(Sure, she would have done even better to buy XYZ today, while it’s still $40, but she didn’t know the future!)

Bob has sold his shares at $45, which is $15 more than his cost basis of $30. Add to that his $0.75/share in premium, and his total profit is $15.75/share x 100 shares = $1,575.

Now, if XYZ went significantly higher still (let’s say $50 at expiration) then Bob might regret having sold that $45 call. He’d miss out on an additional $5 share. However, that number is just opportunity cost (what could have been), not an actual cost. The whole arrangement was still highly profitable.

Now that we’ve covered (so to speak) how this trade works and why anyone would even participate, check out these articles next:

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