Covered Calls Primer: Part 1

Briton Ryle

Updated March 4, 2015

The prolonged stretch of ultra-low interest rates well into its seventh year has sent investors scurrying about to locate yield anywhere they can find it. Most have gravitated toward the higher yielding ETFs, which is fine. They have certainly held their own.

But the more experienced ones, or at least more courageous, have found another source of income generation: options, specifically selling covered calls.

Their appeal is very evident when we consider the percentage returns that can be booked within a very short period of time. Through covered calls you can collect as much as 10% or more on your investment within a single month.

But that’s only when they win. When we look at these investment strategies a little more closely we find that while their winning amounts are high, their winning frequency is low. Let’s first look at what a covered call spread is, and some key factors to consider when putting one together.

Covered Calls

A “covered call” is comprised of two simple positions. First, you have a long position in a stock or ETF, where you own at least 100 shares. Second, you short-sell a call option on that stock or ETF. Your short call is “covered” by your long shares, so that there is no risk of loosing money if the stock surges upward, since the loss incurred by your short call would be “covered” by the profit in your long shares.

To ensure proper coverage, however, you must have at least 100 long shares for each 1 short call option, since options represent 100 shares of the underlying stock. If you have less than 100 shares, say 99 shares, you’re not going to be losing all that much even in a runaway market. But you still want all 100 shares of stock for each short call you sell in order to cut your margin requirement.

Short call options incur a hefty margin allocation if you have less than 100 shares per option, even if you have 99. Whereas if you have 100 long shares, the margin for your short call is completely eliminated, tying up less of your money in the position. Tying up less money is important since the amount of money tied up by the trade affects your rate of return.

Consider the Stock’s Volatility

Speaking of your rate of return, the amount of premium you collect from your short call will vary greatly from stock to stock. The greater the volatility of the stock, the greater the premium you will collect from the short call. Hence, the best stocks on which to structure covered calls would be highly volatile stocks in order to collect the most premium that you can, right?

Not necessarily, since volatility cuts both ways. Remember that while your short call is covered by your long shares going up, you now have long shares which are not covered by anything going down. If the market rises, your long shares will offset the loss incurred by your short call. But if the market falls, there is nothing to offset the loss incurred by your long shares, since short calls cannot reward you with more money than the premium you collected when you sold them.

So while volatility allows you to collect more premium from your short call, it also exposes you to greater loss on the downside via your long shares.

Adding a Third Leg for Protection

But there is a way around this, and that is by using a little of the premium you collect from your short call to purchase a long put that is out-of-the-money. This effectively adds a third leg to your structure, where you now have 100 long shares, 1 short call, and 1 long put. Where the 100 shares cover the short call, the long put covers the 100 shares.

All you need to worry about now is the price you pay for your long put, since paying too much will drastically reduce the profit you collect from your short call, and could even render the entire spread unprofitable once you factor-in the commissions.

Choosing the Right Expiration Months

But there is a way around this too, which is by choosing different time durations for your short call and long put. And it is all centered on an option’s rate of decay.

Options decay in price faster and faster as they approach expiration. For example, an option with 12 months to expiration will decay in price very slowly, while an option with 6 months to expiration decays more quickly, while one with just 2 months remaining will decay faster still. The decay rate accelerates with each passing week, with its last week losing at the fastest speed of all. Just think of it as a comet heading toward the sun, picking up speed the closer it get to its final destination.

This scale of time decay tells us everything we need to know about where to position our short call and long put. Here’s how:

The short call position in this structure can be called your “debt instrument”, while the long put position can be called your “asset instrument”. This is so because your short call is a liability which would cost you money if you wanted to liquidate it early. Your long put, on the other hand, is an asset for which you would collect money if you dispose of it early.

Since your short call is a debt, you would want it to depreciate in value as quickly as possible, so that each passing day will lower the debt you own on that short call. Conversely, since your long put is an asset, you would want it to depreciate as slowly as possible, so that its value is eroded less with each passing day.

In fact, many traders will trade such options based on their time decay rates alone. If your debt instrument decays at a faster rate than your asset instrument, you would earn a profit with each passing day, since you would be left with a debt the falls a great deal more than your asset which falls only a little, allowing you to benefit from the value gap between them as it widens.

Taking time decay into consideration, then, tells us that a short time horizon is best for the short call, while a long time horizon is best for the long put. We would, for instance, short a call with one month to expiration while longing a put with one year to expiration. This ensures that our short call erodes much more quickly than our long put, eroding our debt more quickly than our asset.

Choosing the Right Strike Prices

But we still have the difference in price to worry about, since a long 12 month put will cost considerably more than our 1 month short call. This is where choosing the right strike price comes into play.

Generally we would want to maximize the premium we collect from our short call, and would thus short a call very close to the money; that is, with a strike price very close to the current trading price of the underlying stock. At the same time, we can save money on our long put by purchasing it at a strike that is out-of-the-money by a considerable distance; that is, with a strike price that is below the stock’s current price.

The only thing to watch-out for here is the distance to your long put. The farther its strike price is below the stock’s current price, the less you pay for it; that’s the good thing. But the farther out it is, the less coverage you get if the market falls; that’s the bad thing. Remember that your put option is supposed to cover your 100 shares of the stock, so you don’t want too much of a gap between the stock’s current price and the strike price of your put option.

Based on a typical $100 stock, if you purchase a long put that is $10 below the price of the stock (or calculate 10% for stocks of a different price), you can cut the price you pay for your 12-month put almost in half as compared to a 12-month put at-the-money. Yet its being $10 out of the money means your 100 shares now carry a downside risk of $1,000 ($10 times 100 shares) before your put option kicks-in to protect your shares.

With a configuration such as this (100 shares of stock, a short call at-the-money, a long put 10% out of the money) your maximum risk is about $1,000 (which represents the gap between your 100 shares and your put’s strike price) plus the cost of your put option, minus the premium you collect from your short call option. In average cases, on a stock in the $100 area, your total risk would be around $1,400 or so, given the above described configuration (collecting around $200 from your short call and paying around $600 for your long put for a debit of $400, plus the $1,000 in margin incurred by the gap between your shares and your long put’s strike price).

The Typical Payout

How much of a return can we get from this $1,400 outlay? If you waited a month for your short call options to expire, you could sell your 100 shares and your long put option and probably get back something like $1,550. If all went well, the debt on your short call would be worth zero, while the value of your long put would still be worth around $550 or so. Liquidating everything would thus give you back $550 from your long put and return that $1,000 previously set aside for margin on your shares.

That means you could earn around $150 for a $1,400 investment in one month, which is 10.71% per month, or 128.57% per year if you repeated the procedure every month.

However… and this is a huge however… it all depends on how much the market moves in the meantime. If the market moves up, you would collect less for your long put, potentially causing you to lose more from your put than you collected from your call, turning your 10% monthly gain into a 10% or more monthly loss. If the market moves down you can still lose money in that your long shares would incur some loss which your long put would not be able cover, given that $10 gap between your stock and the long put’s strike price.

The above calculated return, therefore, is only the ideal return you could expect to gain if the market remained perfectly flat during that one month until your short call expired. Now how often does a market remain flat for an entire month? Not often.

Yet there is something we can do to keep the system rolling along even when the market moves on us during that month we are waiting. The key is to continually roll your short call over month after month, continually generating more income while your put expense remains the same. This means we would keep collecting income each month on the call side without incurring additional expense on the put side.

This, though, requires a lot more of an explanation, and will have to be continued in tomorrow’s article.

Joseph Cafariello

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