The Covered Call Strategy for Income

This article was written in August of 2020.

Many assume that the only way to receive income within an investment portfolio is from interest-bearing bonds and/or dividend-paying stocks. However, there is another, rarely used source of potential income – stock options. This article describes how BCWM uses stock options within a “covered call strategy” to generate additional income for our clients.

First of all, stock options are just another type of security that investors can buy or sell, like stocks and bonds. There are two types of options — calls and puts. This article will focus only on call options.

• When you purchase a call option, you get the right to buy a particular stock at a particular price (called the “strike” price).
• If you instead sell a call option, you take on the obligation to sell a particular stock at a particular price, because you are giving someone else the right to buy.

Every option has a number of variables associated with it: an underlying stock, a strike price, an expiration date, and an option premium (what the option costs).

The easiest way to understand all of these option features is through an example. Consider the following:

In this example, you can pay $2 for the right to buy a share of WMT stock at a “strike” price of $145. But after November 20^th, your right to buy WMT at $145 goes away (expires).

After you buy the call option, two things can happen: On or before the expiration date, if WMT stock rises above the $145 strike price, your option is considered “in the money.” In this case, you can exercise your option to buy WMT stock and turn around and sell it at the current market price, profiting the difference. So if WMT goes up to $150, you would have the right to buy it at $145, and could then immediately sell it at $150 for a $5 profit.

But if WMT stock is trading below the $145 strike price, your option is considered “out of the money” and worthless. For example, if the current market price of WMT is $130, then you would not want to exercise your right to buy at the $145 strike price. Paying $145 for something that is worth $130 is a sure-fire way to lose money (in addition to the $2 premium you already paid)!

Buying a call option is like gambling. The $2 premium is your wager. If the stock goes up enough in the next few months, you make money. If it doesn’t, you’re out the $2 wager.

At BCWM, we’re not in the business of gambling with our clients’ money. Instead, we prefer to take the other side of this transaction and become the dealer, so to speak. The covered call strategy allows you to do just that.

The Covered Call Strategy for Income

This strategy is a combination of two positions: you own the stock and you sell a call option against the stock. Owning a stock is straightforward. But understanding the second part, selling a call option, is the key to understanding this strategy.

Selling a call is the exact opposite of the WMT example we described above. Instead of buying the call option, you sell it. That means you give someone else the right to buy WMT stock from you. Also, instead of paying the option premium, you receive it.

In other words, you let someone else take the gamble described in the previous section. In turn, they pay you for it. That’s how this strategy generates income.

Let’s walk through an example of a covered call using the same WMT option as above.

Remember, the covered call strategy requires you to own the stock and sell a call. So, assume you own WMT stock and it currently trades at $130. You don’t expect WMT to go up to $145 in the next few months, but if it did, you would happily sell it there. With that in mind, you would sell the WMT call option and receive the $2 premium.

After you sell the call option, two things can happen:

If WMT stock stays below the $145 strike price, you generate income that you would not have received otherwise. While $2 is not a breathtaking return, keep in mind it is over a short period of time (three months in this example). On an annualized basis, that’s a return of 6.5%, which is about four times as much as WMT’s current dividend yield!

Let’s say WMT does go above the $145 strike price. As the option seller, you still generated the $2 in income, but the buyer on the other side (the person who paid you to take the gamble) is now in the money. They have the right to buy from you at $145, and you have the obligation to sell to them at that price. That is the trade-off with covered calls – you lock in guaranteed income, but you can potentially lose some upside in the stock. However, if you were happy selling WMT at $145 anyway, then this strategy can be a win-win.

When establishing a covered call strategy, there are many variables to consider: underlying stock, strike price, expiration date, and so on. Tweaking any one piece of the equation will affect the others, and ultimately the level of income you are able to generate. So selecting the right option features is crucial to obtaining a proper risk-reward balance.

Managing this strategy within a portfolio requires not only a certain level of knowledge, but also diligent monitoring. The BCWM Portfolio Management team has the experience and expertise to implement the covered call strategy to generate additional income for our clients.

This information is provided for general information purposes only and should not be construed as investment, tax, or legal advice. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed.