Covered Call Writing

Covered Call WritingOptions are viewed by some as speculative investments, and there is some truth to that. When used in certain ways, option trading can be highly speculative, and you can lose everything.

In truth, options are among the most flexible of tools, and can be used to speculate and increase risk, or to reduce the risk compared to standard stock investing.

One way to use options in a reasonably conservative way is through covered call writing.

Covered Call Writing: Prepare to Sell Overvalued Stocks

Options allow investors to agree on future stock trades. The way a put option works is, the seller (writer) of the option sells to the buyer the option (but not the obligation) to buy stock at a certain price from the seller of the option before a certain date.

It helps to highlight with an example.

Bob currently holds 100 shares of ABC stock at $80/share, which he bought two years ago at $50/share. Using the Dividend Discount Model or some other stock valuation method, he believes that the fair price for shares of this company is only $75, so the stock price has gotten a bit ahead of itself, according to his fundamental calculations.

Bob has a few possibilities at this point:

1) He can sell the shares and invest elsewhere. This might be a valid approach, but if the market as a whole is at a rather high valuation, he may have a problem finding attractive investments. Plus, he has to consider all of the capital gains taxes and transaction fees he’ll have to pay if he sells. In this case, selling is only the preferred approach if he can find an investment that is significantly better, even after all taxes and fees are considered.

2) He can continue holding the shares. They’re not too overvalued, so it may not be a bad move. The downside here is that his returns over the next few years might not be so great, if he’s pretty sure the securities he is holding are mildly overvalued right now.

3) As a middle approach, he can sell a covered call on his position.

Covered Call Writing Example

In this example, Bob is okay with holding the shares at $80, but thinks that if the shares go to $85 within the next year, then they’re too overvalued for him. Rather than just wait and see, he decides to be proactive about it. He’s a buy-and-hold investor, and has a low portfolio turnover rate, but he doesn’t want to knowingly hold significantly overvalued stocks.

So, he agrees to sell a covered call on his ABC stock to another investor, Sally. The agreement is as follows: Sally pays Bob a premium of $5/share, and in return, Bob provides Sally the option to buy the shares from him at any time within the next year at a price of $85. The agreement is for 100 shares. The reason Sally pays Bob, and not the other way around, is that Bob is reducing his flexibility by taking on the obligation to sell the shares to Sally if she wants them, for $85/share. Sally is paying for the increased flexibility she now has: she can either not buy the shares, or buy them for $85. Clearly, Sally is pretty bullish on ABC stock, whereas Bob thinks the stock is expensive.

Bob currently owns 100 shares at $80 each, so his position is worth $8,000. The stock pays a 2.5% dividend of $2/share, or $200 for 100 shares each year. In addition, he’ll now receive the option premium of $5/share or $500 for 100 shares this year. His total income from this holding will now be $700/share.

Scenario 1: ABC stock goes to $110
The stock soared in price, so Sally exercises the option and buys the shares at $85. Sally is extremely happy, because she bought the option for $5/share, and then got to purchase the shares at $85 for a cost basis of $90, and can sell the shares immediately at $110. Or she can just sell this option to someone else, so her returns were explosive over this period.

Bob’s feelings here will depend on a few factors. His $80 investment jumped to $110, but he had to sell at $85 and also received $5/share in premiums, so he got returns of $10/share for a rate of return of 12.5% this year on a stock he believed was overvalued. He also got the 2.5% dividend. If not much changed, then he now believes the stock is extremely overvalued, and he’s happy to be rid of it. Of course he would have loved to have had a crystal ball to know that it would go to $110 and to sell it at that level instead, but he didn’t have one, so he had to rely on reasonable valuation methods to determine a fair stock price. So he’s happy.

Now, if it turns out that the company reported amazing news, and it goes to $110 without being overvalued (like maybe it was acquired, or they had a blowout quarter with raised future profit expectations), then he missed out on fundamental improvement in the company.

Scenario 2: ABC stock goes to $90
In this scenario, the stock goes up to $90. Sally buys the stock from Bob at $80/share, so he makes the same 12.5% return plus 2.5% in dividends. Sally’s rather disappointed, because her return is 0% over this period. She neither lost money nor gained money. She got to buy the stock at $85/share, but she paid $5 for that option, so she really paid $90/share, which is what the current stock price is now.

Bob’s pretty happy because he’s rid of the overvalued stock and got a good rate of return while he waited.

Scenario 3: ABC stock stays at $80
Over the course of the year, the stock price ends flat. Sally’s option expires worthless, so she’s disappointed. The money she paid for the premium was wasted.

Bob is rather pleased, because this is primarily what he thought would happen anyway. The stock was overvalued and it didn’t go any higher. If he had not sold the option, his rate of return would have been limited to the 2.5% dividend, but instead, he gets the $2/share in dividends and $5/share in premiums, so he makes $7/share or 8.75%, on a flat stock.

Scenario 4: ABC stock drops to $60
ABC Corporation reports bad news, and the stock drops to $60.

Sally is disappointed for the same reason as scenario 3: she lost her premium.

Bob has mixed feelings. He’s sad to see bad news from a holding of his, but he half-expected this because he believed it to be overvalued. He would have lost $20/share, but because he sold the option, his net loss was only $15/share (plus the dividends he received). He protected his downside slightly, but still had a paper loss.

More Details

The returns that can come from covered call writing can vary substantially depending on what type of option trading you do.

The higher the strike price is compared to the current share price, the less likely it is that the option will be exercised, but the lower the premium will be. The lower the strike price is compared to the current stock price, the more likely it is that the option will be exercised, but the higher the premium will be.

For example, if Bob and Sally’s strike price was $80 instead of $85, then there would be a greater chance that Sally would end up owning the shares, because the stock only has to stay roughly flat or move upward a little bit for Sally to want to exercise the option. But in this scenario, she’ll have to pay Bob a higher premium. For example, Sally might pay Bob $7/share.

Call option pricing is dependent on several variables. For a value investor, the primary variables to consider are:
a) The longer away the option expiration, the higher the premium will be.
b) The more volatile the stock is, the higher the premium will be.
c) The lower the strike price is, the higher the premium will be.

Conclusion

There are a variety of reasons why investors would buy or sell options.

The buyer in this case is speculating that the stock will go up. If it goes up big, she’ll make a ton of money. If it doesn’t, she’ll lose her whole investment. If it goes up moderately, she may break even or get a modest gain.

The seller may be speculating that the stock won’t go up to the strike price, and that he’ll get good returns on his capital. (Selling call options can sometimes provide double digit returns when the option is not exercised). Some call writers don’t even own the underlying stock, so it’s not a covered call. Or, the seller may be a value investor, and is looking to get paid to wait and see if the stock price becomes more overvalued or not.

Out of all these scenarios, the only path I take is the last one: to occasionally write calls if a stock is towards the top end of my fair value assessment. The goal of the seller in this case is to be happy regardless of whether the option is exercised or not; it’s about reducing flexibility to the one thing you’d want to do regardless. If the option expires worthless, then I make a decent extra income on the shares. If the option expires in the money, then I sell stock at a price that I calculated was overvalued anyway.

An enterprising investor can potentially do covered call writing in a conservative way in order to deal with moderately overvalued markets. If there aren’t a lot of good values out there, and your positions are expensive, then consider writing calls at strike prices that you consider to be above the level you’re willing to hold the shares at.

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