A covered call is an options-trading strategy used by professional investors and traders. But individual investors and traders can also benefit from this relatively simple and conservative strategy. Investors can even use IRAs in their Individual Retirement Accounts (IRAs), where many trade strategies are often restricted.
Once the general concepts of a covered call are understood, investors and traders will have added a valuable asset to their arsenal of trading tools.
How a Covered Call Works
A covered call is generally used to generate additional income from a long stock position. The traditional steps of a covered call are buying a stock and simultaneously selling a call option against the stock position (or, even more typically, selling a call option on a stock that is already owned). Before moving ahead, however, let’s quickly take a look at what a call option is.
Call options are legal contracts that give the buyer of the option the right (not the obligation) to buy 100 shares of the underlying stock at the strike price any time before the option expires. The option’s strike price is the predetermined price for buying the stock before the option’s expiration date.
The seller of a call option, meanwhile, has the obligation to sell 100 shares of stock to the buyer of the call option if the buyer chooses to exercise this right. A covered call is said to be “covered” if the seller of the call option owns the underlying shares and is able to deliver the shares if the option is exercised without buying them in the open market. A call is not completely “covered” unless the trader owns 100 shares for every single call sold. For example, if an investor sells five calls, he needs to have at least 500 shares of the underlying stock.
When a call option is sold, premium is collected from the call buyer. This cash premium is paid for the right to buy the shares of stock at the strike price in the future. No matter what happens, it’s the seller’s premium to keep regardless of whether the call option is exercised.
A Covered Call’s Best-Case Scenario
The best-case scenario for a covered call is achieved when the stock moves just up to the strike price at expiration. In this scenario, the stock has moved up to its maximum potential without being called away and the sold call expires worthless. If the stock moves above the strike price at or possibly before expiration, the person who bought the call may exercise his or her right and make the investor sell him the stock at the strike price. This isn’t necessarily a bad thing because maximum profit was achieved but now the investor has relinquished the stock (and has possibly missed out on some upside).
If there is ever a time the investor needs to sell out of the stock before expiration, it is recommended that the option be bought to close as well. If not, the investor will be holding a “naked” call, the risk of which is theoretically unlimited if the stock rallies. Holding a “naked” option is not even allowed in most if not all IRAs.
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.