In this increasingly volatile market, most of what you hear about options is from those buying calls and puts on very short-term directional trades. But that creates a limited window for the underlying stock or index to make the move you expect — this approach is full of inherent risks.
Let’s say you believe a stock is headed over time, so you buy it. You can sell (write) calls against the stock position and earn some income while you hold the stock — and you have time to recover if the underlying loses ground temporarily. The beauty of writing covered calls is that an investor can take advantage of the inherent risk in buying calls to make money — and the profits from selling the calls are an additional return on the investment in the stock.
In my view, the ideal scenario for a successful covered-call strategy is to write calls against stocks that are enjoying a recent uptrend, but with limited potential upside. By selling covered calls, you have the obligation to deliver 100 shares of the underlying stock at the strike price to the buyer, should they exercise the call before the option expires. So by assuming this obligation, you collect a premium upfront as payment for selling the ownership rights of stock at a specific strike price for a given period of time.
For example, if you think shares of Johnson & Johnson (JNJ) are going higher from their current price of around $86 a share, you could buy a JNJ July $87.50 call option for $95 per contract and control 100 shares of stock.
But if you already own JNJ and want to hold it for the long term, but worry that near-term upside is limited, you can write call options — sell one JNJ July $87.50 call contract and collect the $95 premium (cash fee paid to you by the buyer when the option is sold).
In one scenario, JNJ stock stays at or slightly below $86 through expiration, just as you had expected. That means you would get to keep the entire premium, the calls would expire worthless and you don’t need to do anything else.
Another scenario is that the shares don’t settle back down, but continue rising. You could change your mind when JNJ hits the strike and choose to keep the shares by buying back the call and closing your obligation. However, even if you don’t do this and the buyer decides to call the shares away from you, you still turn a profit! That’s because you chose a strike price that allowed you to close out your stock position for a gain if the buyer exercised the call.
Remember, the major risk in writing covered calls is that the stock may decline much more than the protection provided. But if the market bottom is already behind us, then this strategy is very effective in a volatile market. Option premiums are so expensive precisely because of the wide gyrations the market has experienced, so selling option premiums into that volatility affords a call option writer more premium value to cash in.
The other risk in covered-call writing is that once you have written a call against an existing position, you have capped your upside and thus put a ceiling on your return. Using our JNJ example, say the shares shoot up from $86 to $100 in a relatively short period of time. By writing the JNJ $87.50 calls, we have limited our upside in JNJ — because the stock is certain to be called away at $87.50 — so we’d miss out on a 16% rally in the stock.
That’s why, as I mentioned before, it’s best to write covered calls on stocks that seem to have limited upside — they’ve gone up about as far as you expect them to go in the near term. Taking in premium after sharp upward moves in individual stock positions allows investors to get paid to time rallies and insulate gains.
Remember, writing covered calls is a very conservative strategy that can even be implemented in retirement accounts — and, as you have seen, it’s an effective way to ramp up profits on a stock holding, and should therefore be a key income-boosting strategy for all investors.
Bryan Perry is editor of Cash Machine, a newsletter focused on dividends and income investing. His newest service, Extreme Income, also focuses on dividend investing with “income boosters” like momentum plays, option strategies, and more.