Can covered calls help your portfolio?
Covered calls are among the most interesting financial instruments, and one that most average investors are not familiar with. A casual reader who wants to learn about options trading is bombarded with Greek letters (theta, gamma, etc) and a giant list of different strategies, such as iron condor, long butterfly, collar, and so on. That can be too much information, and it can certainly overwhelm a newbie investor. Those who are not prepared could end up losing everything if they start trading options without doing a lot of homework first.
Fortunately, covered calls are relatively easy to learn, and they can be profitable when used correctly. As always, a disclaimer: I’m not a financial advisor, this is all for entertainment purposes only, and you should do your own research and accept the consequences of your actions. (An overall good life rule, that.) With that out of the way, let’s dive in.
In a nutshell, a covered call is a promise you make to sell 100 shares of the stock you own for a certain price at a certain date. You write the call (be it weekly, monthly, quarterly, or a long-term LEAP – long-term equity anticipation security), collect the premium, and face two possibilities. Either the stock price goes higher than the price you agreed on + the premium, or it does not. Based on that, your call gets exercised (your broker sells your shares at that strike price) or it does not (you get to keep your shares). In either case, you get to keep the premium.
This Investopedia article goes into a lot more detail and has some great examples. The amount of premium you can collect when you write the call depends on the time till the expiration (selling a weekly covered call on Monday is more profitable than selling it on Friday due to theta decay), as well as the stock’s IV – implied volatility. IV depends on the supply, demand, and time. Highly volatile stocks like AMC Entertainment or GameStop have IV well above 100%. On the other hand, safer and less volatile stocks such as Coca-Cola have IV as low as 13%, since they’re not expected to make huge price swings. As I’m writing this, Disney’s IV is 21%, Apple’s IV is 29%, etc.
What does this mean for you? Depending on how volatile the stocks in your portfolio are, you can write weekly (or monthly, or farther out) covered calls that are OTM (i.e., the strike price is higher than the stock price), collect that premium, and either wait for the calls to expire worthless, or have them exercised (if the stock price goes up above the strike price), or buy back your own covered calls if their price drops. (You collect the delta on the premium, and get to keep your stocks.)
There are, of course, some caveats. The biggest upside of selling covered calls is milking your portfolio for anywhere between 0.5%-2% per week by selling covered calls and collecting the premium. If you don’t expect the stock price to jump up in the near future, you can keep doing this forever, or at least until the price finally jumps up and your calls finally get exercised. Theoretically, if you were to collect even 0.5% of your portfolio’s total value in premium each week, then use that money to buy more shares and write covered calls on them, the compounded gain would increase your portfolio by 29% a year later. If you collect more premium each week by owning more volatile stocks (let’s say you’re a die-hard GameStop fan), the gains will be that much greater.
Sounds too good to be true, right? That’s because there are also some complications. If the stock price falls rapidly after you write covered calls, you’ll have fewer options than you would’ve had with just your stocks. If the price skyrockets unexpectedly, you’ll miss out on that rally: your gains will be limited by the strike price you’d agreed upon + the premium you collected.
Consider this example: you have 100 shares of BA (Boeing) at $200 cost basis ($20,000 total), and you sold a weekly covered call for the $210 strike price for $1.50. $1.50 x 100 shares = $150 in premium you’ve collected for doing absolutely nothing, or 0.75% return on your $20,000 investment. But let’s say BA announces a huge new plane order, and the stock price shoots up to $230. If you hadn’t sold that covered call, you would’ve been able to sell your stocks for 15% gain: you would’ve made $3,000. However, since your covered call was for $210, your 100 shares get sold for $210 each, and while you’ve still made $1,150 ($10 gain on each share and $150 in premium), you could’ve made $3,000 instead. By collecting that $150 premium, you missed out on $1,850 in gains.
That’s improbable, but not impossible. Back in May 2020, I created a hand-picked portfolio of stocks that had been hit the hardest by the market sell-off. (Energy companies, cruise ships, retail stores, etc.) That portfolio almost tripled in value over the following year, but there were a few key days… On November 9, 2020, Pfizer released their preliminary vaccine data: the world had its first covid vaccine, and it was more than 90% effective. It was a euphoric day, and my portfolio jumped up by 19.6% by the time the market closed. (And yes, I did celebrate with champagne.) If I’d sold covered calls on my stocks earlier, they would’ve been exercised, and I would’ve kept only a tiny fraction of that 19.6% spike. (That means less champagne and more crying myself to sleep.)
Another complication is the tax treatment of your covered calls premium: it’ll be considered short-term capital gains, which are taxed at a higher rate than long-term capital gains (held for 12 months or more before selling) in the US. That might not be what you’re looking for if you want to maximize your returns and minimize your tax liability. On the other hand, if you sell covered calls in your Roth IRA, your gains will not be taxed. For example, last month I grew my Roth IRA by 2.5% just by selling weekly covered calls. That approach may not always work, but when it does, it’s beautiful.
As you can see, this is a complicated topic with many different nuances. The concept of covered calls is not taught in high schools, it’s not promoted in the media, and if you asked 100 random strangers on the street, very few of them would be able to tell you what that is. However, when everything aligns, covered calls becomes a great cash cow. As always, the more you study this topic, the more prepared and efficient you’ll be. Head on over to Investopedia to learn more, and good luck!
What about you? Have you dabbled in covered calls before? Do you use other relatively low-risk options stratagems? Share your knowledge in the comments section!