Picking a Covered Call Candidate
Typically when hunting for a covered call trade, an investor will look for a stock with a neutral-to-slightly-bullish outlook. It may also be advantageous to find a less volatile stock that can rise slowly over the next several months. If a stock is too bullish, it may be better to just buy the stock or a call option so profits are not potentially limited.
One of the goals of a covered call is to profit on the underlying stock as well, so it’s in the investor’s best interest to find a stock that will hopefully gain in value and not move lower or trade sideways.
Picking the proper strike price and expiration month is another decision an investor needs to consider. A strike price should be chosen based on where the investor thinks the stock will be trading at expiration.
Usually for this strategy, an investor picks an expiration date that is three weeks to two months in the future. A longer expiration period can mean a higher premium but the covered call will have to be held longer to reach its maximum potential. A shorter time frame, on the other hand, means less time for the stock to move but also means a smaller premium.
A Hypothetical Example
An investor buys 100 shares of Dollar Tree Inc. (NASDAQ:DLTR) stock, which was recently trading at $93.50 a share, and sells a DLTR April 95-strike call option for $1.50. The investor has noticed the stock has been in a slow uptrend for more than a year. As long as the stock remains below the option’s strike price (95) through April expiration, the option will expire worthless, the stock will remain in the account, and the investor keeps the entire premium.
If the stock goes above the strike price, the maximum profit is capped at $3 a share ((95 – 93.5) + 1.50) and the investor is at risk of having the stock called away. Remember, someone owns the right to buy the stock for $95 a share and will most likely exercise his or her right if the stock is above $95.
An added benefit to this strategy is that the sold call option can lower the trade’s breakeven price. The breakeven point is calculated from taking the difference between what the stock was purchased for and the premium collected. In the example above, it would be $92 (93.50 – 1.50). As long as the stock is trading above $92 when April options expire, the overall position (stock plus short call) is profitable.
Benefits and Final Thoughts
There are multiple ways covered calls can benefit an investor with an IRA account when options strategies are limited. First, it can increase the return on the purchase of just stock alone. Secondly, it lowers the breakeven point of the trade. Third, if the stock decreases in value, it lowers the overall cost basis when buying shares of stock.
Investors must always understand any risks involved and study the many different choices of strategies — including the pros and cons of each — before making a decision for their portfolios, whether they be IRAs or individual accounts.
As of this writing, John Kmiecik does not own any shares mentioned here.