Learning to trade options can be a powerful weapon in your investment arsenal. Trading options can create wealth a lot quicker than the capital appreciation of investing in a stock over a long period of time. However, jumping in the options game without proper education can lead to financial disaster. At Wealthplicity, we take a close look at some of the top options strategies and break them down for you so you can learn to trade options safely and successfully. Today we are going to focus on a very popular option strategy that can be used in a variety of ways, the covered call.
A covered call is an options trading strategy that is created when an investor sells a call option against a stock that he/she owns. An investor will use a covered call if they expect to hold the underlying stock for a long period of time but do not expect the price of the stock to appreciate in the short term.
In essence, a covered call is used to generate income in the form of receiving the premiums from option bids. This helps bolster the return of a stock while the overall capital appreciation is relatively flat.
Income from a covered call premium can be 2-3x as high as the dividend payout from the same stock (depending on the dividend yield). A covered call can provide you three different ways to make money from the same stock. If you successfully perform a covered call, you can collect these premiums, the regular dividend payout, and the capital appreciation from the stock. That is why a covered call is so attractive.
To further breakdown the covered call strategy, let’s review some of the option terminology and how it applies to a covered call.
An Option is a contract that you can purchase that present you the option but not the obligation to buy or sell a specific amount of underlying financial asset at an agreed upon date. Each option contract is worth 100 shares.
A call option gives the holder the right to buy a stock and a put option gives the holder the right to sell the stock. In a covered call, you (the holder) will be the one selling a call option to a buyer.
The Option Premium is the current market price of an option contract. The cost of the contract is calculated by the (Premium x 100 shares). So, if the premium is $2.50, the cost to buy the option is $250
A Strike Price is the price you would be obligated to buy or sell the options contract. In a covered call, this would be the price you will be obligated to sell the shares of the option buyer chooses to exercise the option
A Bid is the price you sell an options contract for. In a covered call, the bid is approximately what you will receive in options premiums per share if you sell the call.
If this still sounds a little confusing, let’s take a look at how and when you would use a covered call.
Step 1: Identify the best stock for a covered call. These stocks would be a low volatile, dividend stock with a decent yield that you plan on holding for a long period of time but do not expect any immediate appreciation in price.
Johnson and Johnson (JNJ) would be a great example of a stock you could apply the covered call strategy. Johnson and Johnson is a household name stock and has been sideways for much of 2020. Just look at the stock chart below, paying attention to its price fluctuation after its March recovery.
Despite some small peaks and valleys, JNJ’s stock price was very stable for much of 2020, rising a mere 2.5% in a little under 8 months.
The reason this stock is so attractive for a covered call is because JNJ is a quality stock you can hold for a long time, expect to realize capital appreciation, receive a consistent, respectable dividend yield of 2.6%, and make money off the covered call premiums as additional income.
Step 2: Perform the covered call on Johnson and Johnson.
Let’s say you purchased 100 shares of Johnson and Johnson at $157 per share for $15,700. Now, you want to perform a covered call at the same time. Below are your Johnson and Johnson Options Table that will allow you to identify which option you want for your covered call:
As you can see, the option highlighted in yellow is the $160 strike price. This strike price is just slightly above the current share price of $157 so, this would be an attractive covered call. The two most important elements of this option are the strike price and the bid.
Again, the strike price is the amount you agree to sell the shares for if the buyer exercises the option and the bid is the amount of premium you can expect to earn when you sell the option.
If you sell the option, you will receive $80 (bid of .8 *100 shares is the option cost) from the buyer and be obligated to sell all 100 shares at $160 if the buyer exercises the option at a 3-month expiration date.
After 3 months, if JNJ rises to $159 but stays under the strike price of $160, the buyer will not force you to sell the option at the expiration date. The option will expire worthless, you keep the $80 premium as income, keep the 100 shares and you will keep any dividend yield paid to you during this time. Again, three great ways to make money off the same stock.
There is also a limited maximum loss to a covered call, as well as a limited maximum gain. The maximum loss is limited to the price paid for the asset, minus the option premium received. The maximum gain is limited to the strike price of the short call option minus the purchase price of the stock, plus the premium received
For many income investors looking to bolster their income from their stocks, a covered call is a great strategy. The key is to find a quality dividend stock with low volatility. If you expect a small appreciation of the stock, this could be an excellent opportunity to gain additional income from the covered call.
Any option is risky, so make sure to do your due diligence to understand your risk tolerance before you make any investment.