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Covered Calls Primer: Part 2

Written By Briton Ryle

Posted March 5, 2015

With yield being so hard to find in today’s ultra-low interest rate environment, many investors have been employing various creative – and often risky – income generating alternatives, such as selling covered call options on their stock holdings. Even the simplest of covered call structures can deliver as much as 1% to 2% in extra returns per month, making call writing something to seriously consider.

Yesterday, I did precisely that, outlining the basic ins and outs of selling covered calls – from how to cover your short calls with an appropriate amount of long shares in the underlying stock, how to cover your long shares with long puts, how to determine the optimum placement of your options on the time and price scales, and what your typical risks and rewards would be in any given market direction.

In Part Two of our look at the ins and outs of covered call writing, we’re going to look at how to extend a covered call structure beyond just the first iteration which is typically one month. We’re going to look how to keep the ball rolling indefinitely by keeping our short call structure rolling month by month.

Why Once is Never Enough

Of course, there is nothing wrong with initiating a covered call structure (which consists of at least 100 shares of the underlying stock and a short call option, with an optional long put option to protect the 100 shares) and running it for just one month. In this case, when the short call expires, the entire position would be closed including the sale of the 100 shares of stock in addition to the long put if you had one, and the structure will have been completely closed.

The trouble with running these structures for just a single month is that your success is hit-and-miss. Some months you’ll have made a profit if the market remains relatively flat or at the very least returns back to where it was when you first initiated the structure. Yet there will be several months when you’ll have lost money, especially during those times when the market moves significantly either up or down.

In a strong upward more, for instance, your long put would lose more money than you collected from your short call, whereas in a strong downward move, your long stock shares would lose money across that 10% gap between the stock’s initial price and the put option’s strike price that we considered yesterday. Taking a single shot like this requires a sniper’s accuracy, where you have a narrow target to shoot at, over which target the market must remain – something which is very rare, especially in volatile markets as we are just now starting to see once again.

Indeed, to generate consistent profit using covered call structures over the long haul, simply opening and closing our structures month by month is not going to do it. We need to look at how to keep the structure open for a year or more, allowing us to reduce our expenses and increase our income over time.

To accomplish this we need to continually roll the short call over month after month when it expires.

Collecting the Right Amount from the Short Call

In yesterday’s primer we considered how a 12-month option is the ideal time frame for our long protective put, since we want our put to lose as little value as possible day by day. Yet buying a 12-month put affords us another advantage in that we can keep the entire short call structure alive for an entire year without having to spend more money on another put.

On average, a 12-month put option that is about 10% out-of-the-money will erode at a rate of approximately $10 to $15 per week, depending on the underlying stock’s volatility. The figures I cite here are for options on the SPDR Dow Jones Industrial Average ETF (NYSE: DIA) which tracks the Dow Jones Industrial Average of 30 large cap U.S. stocks. At that erosion rate, a 52-week put option would cost you between $520 and $780, depending on the strike price you choose.

This means that in order to make a profit, the income we collect from our short calls should be greater than $15 per week, or $60 per month. As an extra note, DIA options also trade with weekly expirations in addition to the normal monthly expirations. Thus, you don’t have to trade the monthlies, but can sell the weeklies for even faster erosion speeds. The only problem with weeklies is that you will not earn very much for strike prices outside of a very narrow band, forcing you to stay very close to the market to earn a decent premium, which can adversely affect you if the market moves in a sudden spurt as will see below.

To generate at least $60 per month from a short call, then, we would need to sell at a strike price that is fairly close to the stock’s current price, within $5 or so. For example, if the DIA is trading at, say, $181, you would need to sell a four-week short call with a strike price no higher than $185.5, which is currently trading for around $60. Being some $4.50 out-of-the-money means that your long DIA shares would still be able to earn some $450 of upside profit before being cut-off by your short call, which is a very nice bonus to have.

However, if you want to increase the amount you collect from your short call right away, you could sell the call at a strike price that is closer to the market, perhaps even as close as $183, just $2 away. This would fetch you some $160 as of this morning, earning you a full $100 more than what you need to break even. Plus, your long DIA shares would still have $2 of upward movement to benefit from before the short call chokes them off, earnings you an additional $200 in stock appreciation.

The important thing to make certain of here is that you are collecting more from your short call than the long put is costing you on a weekly basis, ensuring you cover all of your initial outlay by the time your put’s 12 months are up.

How to Keep the Momentum Rolling

Of course, after the first month, your short call will be expired and be removed from your portfolio, with an appropriate adjustment to your account depending on the price the underlying stock closed at. But your long put option still has 11 months remaining. It is now time to return to the call option well and fetch us another bucket of liquid profit.

Once your first call option expires, you would then short sell another call option the next expiration month over, following the same strike selection procedure described above, ensuring we collect at least enough to cover our long put’s erosion rate. This is what is meant by “rolling” options forward, which is also employed on futures contracts, bonds, and anything else that has an expiration date.

Under optimum circumstances, this rolling could generate as much as $100 profit or more each month for the duration of your long put option. In our example above, selling a call that is about $2 out of the money each month would earn $160, which gives us an extra $100 per month over and above our long put option’s erosion rate. By rolling our short call each month for 12 months until our long put expires, we could generate $1,200 of profit over and above our expenses which totalled $1,400 as explained yesterday ($1,000 risk on the long shares plus $600 cost for the long put minus $200 income from the short call).

Notice the rate of return? That $1,200 gain over your risk and cost of $1,400 equates to an annual return of 85.71%, all thanks to the procedure of rolling over your short call month after month while still holding on to the same long put option until it expires.

This is the whole idea behind the covered call structure, as we lay the initial foundation down once and then simply keep the ball rolling month after month, without having to lay down another foundation until the put option expires a year later.

But before we quite our day jobs to take up covered call trading full time, there is one important detail we must take into account… the market’s movement in the interim.

How the Market’s Movement Cuts Into Profits

The above illustrated returns have enticed many traders to try their hand at covered call structures with usually more disastrous than beneficial results. The reason most fail to keep the ball rolling successfully for long periods of time is because the market has a nasty habit: it keeps moving on us.

The returns depicted above are what your call structure would generate if the market remained almost flat during that 12-month period, which is nothing less than wishful thinking. The market will move up and down month after month, and those moves can harm our short call structure in two main ways:

First, if the market moves up past our short call’s strike price, our short call would end up costing us money as it expires in-the-money. In order to pay that debt off, we would need to either use some of our cash to buy back the short call just before it expires, or allow the system to automatically sell our 100 shares of stock to cover the call when it expires.

Either way we will be losing money, for in order to keep the ball rolling the next month, we would need to purchase another 100 shares at the higher market price. The net result is a stock sale at a lower price (the short call’s strike) followed by a stock purchase at a higher price – and this means we would have sold low and bought back high, which is not a winning scenario.

A second way we can lose money is when the market falls a sizable amount, whether it overtakes our long put’s strike price or not. That drop in the stock’s price means we now need to short the next month’s call option at a lower strike price when we roll it. If the new short call’s strike price is below the original price at which we purchased our 100 shares, then the short call will have effectively locked in a loss in our stock position, since we would not be able to recoup our stock’s losses even if the market moves back up again – for the short call would be sitting in the way, blocking our path to recouping our stock’s losses.

Counting on Short Calls to Save the Day

But we can still make this process work if we keep collecting a little extra from our short calls each and every month by selling them just a little bit closer to the market price of the stock. Remember that $100 of extra profit we receive by shorting a call that is just $2 out of the money? That extra profit would increase to $150 by shorting at $1 out of the money, and up to $200 extra profit by shorting at the money. Thus, we could slowly earn back any of the above mentioned losses (the loss in the short call when the market moves up, and the loss in the stock shares when the market moves down) simply by collecting a little more from our short call each and every month.

However… it seems there are a lot of howevers in covered call structures… the market has a way of moving against you yet again. Just when you think you have clawed back enough extra premium from the rolling of your short calls to make up for last month’s losses, along comes another sudden movement in the market – whether up or down – which incurs more losses that your short call has to earn back next month.

In the end we are left with a backlog of losses that our poor overworked short call simply can never reclaim with any measure of consistency over time. Sure, we can tread water for a few months and even reach a nice return of 30 to 40% in 3 or 4 months. But when volatility re-enters the market place, you’d be amazed at how quickly those 3 or 4 months’ worth of gains can be eroded away, even in just a single month.

For all the time and all the work and all risks associated with short call structures, the verdict is entirely a simple one: short call structures fail over the long run.

An Easier Alternative

There is, however, an easier alternative to generating high yield in a low interest rate environment, and that is to simply trade one of the best high yield funds around – the UBS E-TRACS 2-Time Leveraged Long Wells Fargo Busienss Development Companies ETN (NYSE: BDCL), which I describe in this article.

BDCL has been averaging an annual yield of 18% since its inception nearly 4 years ago in June of 2011. Yet it doesn’t offer just high dividends alone, but also promises exceptional capital gains as well. It is high correlation to the U.S. 10-Year Treasury’s yield, meaning that it is expected to rise in value as interest rates rise over the coming several years, delivering handsome capital gains in addition to its highly attractive dividends.

With this and other high yielding funds, investors can simply buy and hold and not have to worry about covering and rolling short calls month and month, which can leave you exhausted and a nervous wreck during those periods of high market volatility which are now once again the norm.

Even so, this discussion on the ins and outs of covered call structures could prove useful if only to shed some light on what they are really all about, hopefully leaving us better informed on how they work, and all the wiser on how they don’t work.

Joseph Cafariello