Volatile stock prices are thrusting the humble covered-call strategy to the forefront of the options market.
The strategy entails selling a call option with a strike price higher than the underlying stock price—and that generally expires in under three months. It’s well suited for investors who are looking for ways to manage long-term stock positions that are suddenly facing upside resistance. (Call options give a buyer the right to purchase an underlying asset at a set price and time.)
Selling calls on stocks that an investor owns—hence “covered”—can enhance returns, and the income received for selling the call can even modestly hedge the position by the amount of money received for the call. That income can add up for investors who systematically use the strategy as a potential source of extra return on their stock. Think of it as akin to collecting rent, especially on stocks with stalled prices.
The covered-call strategy is often misunderstood. Many investors erroneously believe that the strategy limits the potential profit of owning the stock to the call strike price. If the stock price rises to, or beyond, the call strike price, they think they are stuck selling stock at the strike price.
The reality is different. While call and put options on individual stocks and exchange-traded funds can technically be exercised at any time, they are infrequently exercised far in advance of expiration, even when stock prices exceed the call strike price. Why? The person on the other side of the trade usually seeks to avoid paying “time premium” to buy the call. Instead, the call is likely to be exercised at, or near, the expiration date when options prices tend to mirror the stock price without any fear or greed premium.
There is one exception: If an expiration cycle covers when a company pays a dividend, investors must be careful. Dividend payments attract predatory traders who exercise options early in order to collect those payouts.
Ideally, the stock price remains below the call strike price at expiration. In that case, the money received for the call is kept. But if the stock price surges above the strike price before expiration, it gets interesting.
Investors can handle this in two key ways. They can sell some stock, cover the calls, and reset the trade at a higher strike price that reflects the stock’s new trading range. Everyone complains about selling stock and incurring taxes, but selling stock to cover the cost of buying back a call can be a disciplined way to book profits. Many investors likely wish they sold some stock before the current market downturn.
Calls also can be “rolled” to a later expiration date. The idea that rolling or adjusting positions is expensive is also not quite true. Investors can roll options at strike prices that are lower than the stock price, essentially injecting the option with a time premium to make it less appealing for someone to exercise the contract early. By skipping from strike to strike, and expiration to expiration, investors can often keep generating income, while buying time for the stock price to normalize.
There is never a free lunch when it comes to markets and investing, but stop thinking that a covered-call strategy can’t be broken apart. Once a call is sold on a stock, investors should consider the stock and the call to be related entities that can be, if needed, individually managed. Anyone who remembers that fact will never look at the humble covered-call strategy in quite the same way.
Trading is a mix of art and science that is tempered by discipline and experience. Successful investors know when it pays to be a fox or a wolf.
Steven M. Sears is the president and chief operating officer of Options Solutions, a specialized asset-management firm. Neither he nor the firm has a position in the options or underlying securities mentioned in this column.