January 4, 2019
Options can be an intimidating financial instrument, but they needn’t be viewed that way. Yes, there are complex option strategies and inherent risks associated with options, even with exchange-traded puts and calls. However, one strategy that could potentially enhance portfolio returns with limited risk is covered call writing. In fact, this is the one option trading strategy that’s allowed in individual retirement accounts.
First a few basics on options. A call is an option that allows the buyer the option to purchase 100 shares of stock at a specific price, while also obligating the seller of the option to sell 100 shares of stock at a specific price. The buys of the call pays the seller a price (the option premium) for the ability to buy the stock at a set price, while the seller receives the premium in exchange for committing to sell the stock at the agreed upon price (the strike price). The effect of this transaction and associated exposure is as follows:
The buyer of the call option: pays the premium (which may be lost if the underlying stock does not rise in price sufficiently over the strike price) and if they exercise the option, would be required to buy from the option seller the 100 shares of stock at the strike price. In effect, the call buyer is bullish on the stock’s appreciation potential, but the option allows the buyer more flexibility in taking advantage of that appreciation potential.
The seller (or writer) of the call option: would receive the premium from the buyer (the writer gets to keep this cash no matter what happens next) and would be obligated to sell 100 shares of stock at the strike price should the buyer of the call decide to exercise the option. The writer of the call is exchanging their potential upside on their stock investment for some cash today.
How this might work in practice. Suppose I have 100 shares of Ford Motor Company Tii:F) stock in my account. The stock currently trades for approximately $10 per share and pays a dividend of $0.60 per year, for a 6% dividend yield. Now I could be happy just sitting on my $1,000 in Ford stock and collecting my $15 dividend each quarter. Or I can try to enhance my returns by writing covered calls. Currently the March 2019 call with a strike price of $11 has a premium of $0.29. So in exchange for a $29 premium, I am giving up all upside beyond the strike price. So if Ford goes to $15 by the expiration of the March option, I will sell for $11 and received $30 in dividends but I give up the extra $4 I would have received had I not written the call. Conversely if the stock goes nowhere for the next 6 months, I still have my 100 shares worth $10, plus $30 in dividends, plus an additional $29 in option premium, raising my total return from 6% annualized ($30 ÷ $1,000 x 2) to 11.8% annualized (($30+$29) ÷ $1,000 x 2). Of course, if the stock price goes down, I will still incur the losses, but those will at least be partially mitigated by the premium received.
Volatility typically has a direct relationship with option premiums, so if you are considering writing a call on a more volatile stock, the premium you receive will likely be higher, but so will the likelihood of missing upside potential if the shares are called away.
Dividend paying stocks are typically less volatile, resulting in lower option premiums, but this might be offset by both the receipt of dividends and the lower likelihood of the stock being called away.
Ultimately there may be tax consequences for covered call writing, which makes doing so in a tax-deferred account like an IRA more convenient. Ultimately, writing covered calls may be an easy (I actually wrote a call against a position in my IRA account while writing this) way to enhance your returns over the long run.
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