Investors looking for a low-risk alternative to increase their investment returns should consider writing covered calls on the stock they have in IRAs. This conservative approach to trading options can produce additional revenue, regardless of whether the stock price rises or falls, as long as the proper adjustments are made.
Mechanics of Covered Call Writing
A single option, whether put or call, represents a round lot, or 100 shares, of a given underlying stock. Call options are upwardly speculative securities by nature, at least from a buyer's perspective. Investors who purchase a call option believe that the price of the underlying stock is going to rise, perhaps dramatically, but they may not have the cash to purchase as much of the stock as they would like. They can, therefore, pay a small premium to a seller (or writer) who believes that the stock price will either decline or remain constant. This premium, in exchange for the call option, gives the buyer the right, or option, to buy the stock at the option's strike price, instead of at the anticipated higher market price.
The strike price is the price at which the buyer of a call can purchase the shares. Options also have two kinds of value: time value and intrinsic value. For example, a call option with a strike of $20 and a current market price of $30 has an intrinsic value of $10. The time value is determined by the amount of time that is left until the option expires, so if the option in this example is selling for more than $10, the excess of that price is the time value.
Options are decaying assets by nature; every option has an expiration date, usually either in three, six or nine months (except for LEAPs, a kind of long-term option that can last much longer). The closer the option is to expiring, the lower its time value, because it gives the buyer that much less time for the stock to rise in price and produce a profit.
As mentioned, covered call writing is the most conservative (and also the most common) way to trade options. Investors who write or sell covered calls get paid a premium in return for assuming the obligation to sell the stock at a predetermined strike price. The worst that can happen is that they are called to sell the stock to the buyer of the call at a price somewhere below the current market price. The call buyer wins in this case because he or she paid a premium to the seller in return for the right to "call" that stock from the seller at the predetermined strike price. This strategy is known as "covered" call writing because the writer/investor owns the stock that the call is written against (as opposed to a “naked call” where he doesn't own the stock). Therefore, if the stock is called, the seller simply delivers the stock already on hand instead of having to come up with the cash to buy it at the current market price and then sell it to the call buyer at the lower strike price.
An Example of a Covered Call
Harry owns 1,000 shares of ABC Company, which has a current share price of $40. His research indicates that the price of the stock is not going to rise materially any time in the near future. He decides to sell 10 $40 calls to profit from this. The current premium on this option is $3, and they are due to expire in six months. Harry is therefore paid a total of $3,000 for taking on the obligation to sell the stock at $40 to the buyer if the buyer chooses to exercise the option. Therefore, if the stock price stays the same or declines, Harry walks away with the premium free and clear. If the price were to rise to $55, the buyer would exercise the option and buy the shares from Harry for $40, when they are worth $55 in the market.
Normally, though, most investors would sell calls that are out of the money (that is, with a strike price that is higher than the market price of the underlying asset), such as $45 or $50 call options, to try to avoid being called, if they plan on hanging on to the shares for the long term. They will get fewer premiums but will participate in some of the upside if the stock appreciates. (For an alternative to covered calls, take a look at our article about Adding A Leg to your option trade.) If the price of the underlying asset rises significantly and crosses the strike price, the call option goes “in-the-money." In such a situation, the buyer exercises the option to buy the asset at the pre-decided price, which is now lower than the current market price, thus benefiting from the contract. But the call writer is left with modest gains from the premiums earned.
Advantages of Covered Call Writing
One of the best features of writing covered calls is that it can be done in any kind of market, although doing so when the underlying stock is relatively stable is somewhat easier. But writing covered calls is an excellent method of generating extra investment income when the markets are down or flat. If Harry in the above example were to repeat this strategy successfully every six months, he would reap thousands of extra dollars per year in premiums on the stock he owns, even if it declines in value. Covered call writers also retain voting and dividend rights on their underlying stock.
Limitations of Covered Call Writing
In addition to having to deliver your stock at a price below the current market price, getting called out on a stock generates a reportable transaction. This can be a major issue to consider for an investor who writes calls on several hundred or even a thousand shares of stock. Most financial advisors will tell their clients that, while this strategy can be a very sensible way to increase their investment returns over time, it should probably be done by investment professionals, and only experienced investors who have had some education and training in the mechanics of options should try to do it themselves. There are other issues to consider as well, such as commissions, margin interest, and additional transaction fees that may apply. Covered call writers are also limited to writing calls on stocks that offer options, and, of course, they must already own at least a round lot of any stock upon which they choose to write a call. Therefore, this strategy is not available for bond or mutual fund investors.
The possibility of triggering a possible reportable capital gain makes covered call writing an ideal strategy for either a traditional or Roth IRA. This allows the investor to buy back the stock at an appropriate price without having to worry about tax consequences, as well as generate additional income that can either be taken as distributions or reinvested.
The Bottom Line
Although the strategy can be somewhat involved, covered call writing can provide a means of generating income in a portfolio that cannot be obtained otherwise. There are no hard and fast parameters that show how profitable this can be, but if done carefully and correctly, it can easily increase the overall yield on an equity holding—or even an ETF—by at least a percent or two per year.