Beyond generating income: Using covered calls for other investment strategies

Many investment objectives

Most investors want rapid growth in portfolio value and portfolio income that is high and growing. Unfortunately, it is impossible to get it all. Investors, therefore, must prioritize.

One tenet of financial planning is to divide portfolio assets between growth-oriented investments and income-oriented investments based on age. Specifically, it is frequently suggested that one’s age be invested in income-generating investments and 100 minus one’s age be invested in growth-oriented investments. Following this guideline, a 20-year old would have 20% of assets in income-oriented investments and 80% of assets in growth. An 80-year old, however, would have 80% of assets in income-oriented investments and 20% in growth.

Covered calls, it would seem, fit only into the income-oriented type of investments since the premium received from selling covered calls does two things. First, it increases cash income, and, second, it places a limit on potential stock price gains, because the sold stock limits how much a covered call seller can profit from a stock's appreciation.

The covered call strategy, however, should not be relegated only to income-oriented investors. As the following examples illustrate, a wide range of investors can benefit from covered calls. From long-term investor to short-term investor, from casual trader to aggressive trader and from growth-oriented risk taker, to income-oriented conservative, the covered call strategy can help investors achieve investment objectives.

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The long-term investor with price targets

The category long-term investor commonly denotes the buy-and-hold approach to stock ownership. As long as a company’s sales and earnings and possibly dividends are growing, this type of investor typically rides the ups and downs of stock price cycles. Nevertheless, long-term investors occasionally do sell a holding, and this is where the covered call strategy can help.

Assume today is March 1, and long-term investor Tony has owned 500 shares of XYZ stock for several years. Assume also that he has been pleased to have participated in XYZ’s price rise from $30 per share to $58 over the last five years. Recently, however, Tony has read reports that XYZ’s growth may be slowing. As a result, Tony has been thinking of selling his XYZ shares. Since he has no specific alternative investment idea right now, Tony does not want to sell his XYZ shares immediately.

Given this lack of urgency and a positive outlook for the market for the coming three to six months, Tony decides to sell a covered call rather than sell his XYZ shares today.

Specifically, with his 500 XYZ shares trading at $58 each, Tony decides to sell five July 60 calls at $2.80 each. $60.00 plus $2.80 is $62.80, so, if these calls are assigned, it is the same as selling the shares at $62.80 per share, which is 8.2% above XYZ’s current price of $58.00. If the calls expire unexercised, then Tony keeps the premium of $2.80, which is 4.8% of $58.00. The time period from March 1 to July expiration in this example is 108 days, so this is an excellent return for this time period.

Tony, has a stock he is willing to sell if it rises 8%, uses the covered call strategy to target this selling price and to bring in 4.8% cash income over 108 days if the call expires unassigned. Either way–assigned and selling the stock, or unassigned and keeping the stock–Tony will feel he has won. However, Tony must realize that, by writing calls against his stock position, he may miss out on potential price appreciation above the strike price.

The occasional trader

Within the category of self-managed investors, many people do not look at their portfolio every day or even every week. Although this type of investor does not worry about day-to-day market fluctuations, they know the stocks in their portfolio and has a rough idea of what is a low price and what is a high price for each holding. It is this knowledge of the portfolio holdings that makes the covered call strategy particularly useful.

Assume that Patricia has a portfolio of twelve stocks that generally matches the performance of the overall market as measured by the S&P 500 Index. Within her portfolio, however, are some stocks that Patricia is indifferent about owning. Her assessment is that these stocks trade in a range, and she would be happy to sell them at the high end of that range. If they fall back to a price level she finds attractive, then she would consider adding them back to her portfolio. It is on stocks at the high end of their trading range that Patricia uses the covered call strategy.

Consider the stock QRS as an example. The stock has fluctuated between $28 and $36 over the past year and is currently trading at $34. Patricia is willing to hold QRS because it has proven to be a stable performer in the past, but she is also willing to sell her shares if she can get a price close to the 52-week high of $36. If she does sell, Patricia has several other stocks on her watch list that she is willing to own, many of which are at the low end of their 12-month trading ranges.

Patricia therefore decides to sell a 60-day QRS 35 call for $0.90 per share. If QRS is above $35 at option expiration, then Patricia will sell her shares at an effective price of $35.90 (the strike price of $35 plus the option premium of $0.90), which is 5.5% above the current price of $34. If the call expires unassigned, then the premium of 90 cents is kept as income. 90 cents is approximately 2.6% of $34, which is a very attractive rate of income for 60 days.

As mentioned above, Patricia does not look at her portfolio every day or even every week. Rather, she reviews it from time to time and makes a personal decision about which stocks she is willing to sell and at what price.

If a particular stock is close to a selling price in Patricia’s opinion, and if a call option will help her achieve the desired price, only then will Patricia use the covered call strategy. If a stock is at the desired selling price when she reviews her portfolio, then Patricia will usually just sell it. Over the course of a typical year, Patricia might sell covered calls on four or five stocks that approach a price at which she feels comfortable selling. The rest of the year, Patricia is happy to own her stocks and collect the dividends they pay. Patricia fits the profile of the occasional trader.

The active, income-oriented investor

Another group of self-managed investors not only looks at their portfolios every day, they also make one or more trades during most months. This style of investing—or trading, if you prefer to call it that—generally requires frequent attention to the market and to the individual stocks that are owned. And covered calls are often a major component in this approach to investing.

So-called active, income-oriented investors generally have several stocks that they watch and attempt to buy on market dips and sell on market rallies. As the market rises and falls, these investors find that their portfolio is constantly switching from cash into stocks and back into cash. There is no guaranty of success in such an endeavor, but the premiums received from selling covered calls provides both income in sideways to rising markets and a small amount of cushion during market declines.

Consider the case of Joaquin, an avid stock market enthusiast, who follows the price action of 20 stocks and usually has positions in four or five of these stocks at any given time. Joaquin frequently sells covered calls to generate income.

At least two or three times a week, Joaquin goes over his stock charts, and, when he feels the time is right, he buys one of the stocks on his list and sells either a 30-day or 60-day covered call. His goal is to sell a call with a strike price that is two or three percent out of the money with a premium that is at least equal to 1% per month.

For example, when DEF stock was at trading $43.80 on July 21, Joaquin was able to buy 300 shares of DEF stock and sell 3 DEF September 45 call for $0.95. Most importantly, DEF stock met Joaquin’s criteria for being at the right time and right price to buy. His analysis indicated to him that DEF would trade sideways or up, and the September 45 call also met his covered call criteria. The 45 call, being $1.20 and 2.7% out of the money, meets Joaquin’s distance-to-strike-price criteria. Also, the premium of $0.95 is slightly more than 2% of $43.80. Given that July 21 is 60 days to September option expiration, this covered call meets his premium-level criteria of approximately 1% per month.

Entering the DEF covered call position (buy 300 DEF shares and sell 3 DEF September 45 calls) is the easy part of Joaquin’s strategy. Investing this way is also easy if the price of DEF stock remains stable or rises. Come September expiration, if DEF stock is between $43.80 and $45.00, then the DEF September 45 call will likely expire worthless, and Joaquin will most likely sell another DEF call with a later expiration date, assuming that his premium-level criteria is met. He may, of course, choose to sell his DEF stock and stay in cash or make another stock purchase.

The difficult part of Joaquin’s covered call strategy comes when the price of DEF stock declines. If the stock declines less than the call premium received, then at least he will break even or have a small profit. But if DEF declines more than $0.95 in this example, then Joaquin has a difficult decision to make. Should he hold DEF stock hoping for a rebound in price? Should he sell and take a loss, hopefully a small one? Or, when his September 45 call expires, should he sell another call with a later expiration date and a lower strike price?

There are no right or wrong answers to these questions. Every trader must make these decisions individually based on their market forecast. Joaquin, however, enjoys both the process of following the market and his list of stocks and the challenge of trying to buy good stocks at good prices.

For Joaquin, the covered call strategy is a serious hobby. He devotes four or five hours every week to his investing and trading. He reads articles on Fidelity’s Website, he listens to market commentary on television, and he looks at his stock charts several times each week.

A few years ago, when Joaquin decided that he wanted to study the market and trade the covered call strategy seriously, his first several months were frustrating. Initially he felt that he was picking the wrong stocks at the wrong prices, and his results after six months were below break even. But Joaquin committed himself to getting better.

Today, Joaquin enjoys the process of following the market and reviewing his stock charts. He still has losing trades, as every trader does, but Joaquin has learned with experience to take the emotion out of investing. The covered call strategy has added a new activity to his life and he has met people at work and socially with the same interest.

Getting the thinking right

The covered call strategy, regardless of how you use it, requires a shift in thinking away from “buy-and-hold investing.”

First, you must accept that you can’t have it all. You can’t get high income and unlimited profit potential. Therefore, you must choose. Perhaps, in part of your portfolio, buy and hold is the strategy you follow. However, in the covered call part of your portfolio, you must set objectives. Do you want to sell the stock at the effective selling price of the covered call? Remember, the effective selling price of a covered call is a stock price equal to strike price plus the call premium.

Alternatively, is your goal to receive the income that the call option premium represents? And if your goal is to get income, do you want to use covered calls in a low-key, opportunistic way? Or do you want to use covered calls consistently and actively with specifically stated guidelines for selecting covered calls?

Whatever you choose—and there is no right or wrong way to use covered calls—it is best to state your goals in advance and to have a plan for the stock price rising, falling, or staying in a narrow range.

What will you do if the stock price rises above the strike price of the covered call? Will you buy back the call to avoid assignment, or will you simply let the stock be called away? And what if the stock price falls? Will you continue to hold the stock, or will you close the covered call position at a predetermined price level?

The covered call strategy can help a variety of investors target their personal objectives. Long-term investors can sell a covered call when a specific holding approaches a targeted selling price. Self-directed investors who review their portfolios periodically can sell covered calls to target the goal of increasing portfolio income. Finally, active, income-oriented investors can use covered calls consistently to target income generation.

How the covered call strategy is used depends on an individual’s investing style and on the objective. Whatever the investing style and whatever the objective, thinking differently than a traditional buy-and-hold investor is required.

Key takeaways

Investors cannot have it all. Portfolios should be divided into parts that target growth and parts that target income.

The covered call strategy does not fit only in the income category of investments.

Covered calls can be used to pursue a range of investment objectives, such as selling stocks at target prices, generating extra income from time to time, and attempting to generate consistent income with a regular program of buying stocks and selling calls.

However it is used, the covered call strategy requires planning redundant. Objectives should be established before a covered call is sold. Also, what-if? scenarios should be considered so that an investor will know what to do if the stock rises or falls more than expected when the covered call position is established.

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Article copyright 2013 by Chicago Board Options Exchange, Inc (CBOE). Reprinted with permission from CBOE. The statements and opinions expressed in this article are those of the author. Fidelity Investments cannot guarantee the accuracy or completeness of any statements or data.

A covered call writer forgoes participation in any increase in the stock price above the call exercise price, and continues to bear the downside risk of stock ownership if the stock price decreases more than the premium received.

Options trading entails significant risk and is not appropriate for all investors. Certain complex options strategies carry additional risk. Before trading options, please read Characteristics and Risks of Standardized Options. Supporting documentation for any claims, if applicable, will be furnished upon request.

Charts, screenshots, company stock symbols and examples contained in this module are for illustrative purposes only. 668390.3.1