Covered calls are an excellent way to dramatically increase the income you receive from your portfolio. Many times, in fact most times, it can double or triple the dividend yield of a stock. In Part 1 of this series, I discussed the basic concepts of executing a covered call strategy. While it is a relatively low risk strategy, it is important to grasp what risk you are taking on, and how to mitigate it.
Part 2 continued the series, and discussed the best way to select stocks that will form the foundation of your covered call strategy. More than half the battle in covered calls is making sure that you own great stocks that do present liquid (i.e. tradeable) call options with a reasonable premium (the money you get for selling a covered call).
So now that you know which stocks to own and the basics of covered calls, it is time to examine how to select the right call option to sell. The factors that you have to control are:
- What Strike Price do you want to sell the option and
- How far out into the future you want to sell the option or choosing the expiration date.
These factors will dictate how much premium you receive, and whether, ultimately the stock will get called away from you. So these factors are very important.
Choosing a Strike Price:
The goal of choosing a strike price is to weigh the tradeoff of a price closer to the current stock price where you will get more of a premium, but you will also have a much higher probability of having the stock called away from you. Alternatively, if you choose a higher price, your premium will be less but you will have less chance of the stock being called. Also, if a stock does rise, you will take more advantage of the price increase. At Chaikin Analytics, we incorporate OptionsPlay into our product, and they do a very nice job of translating options strategies into understandable English.
Let’s take a look at this strike price tradeoff by examining two Applied Materials (AMAT) calls both with the same June 7, 2019 expiration (about 1 month in the future):
You can see AMAT is currently trading at $41.82. If I choose a strike price of $43, there is a relatively high likelihood that the stock will be called away. The POW: (Probability of expiring Worthless) is only 62% – meaning that there is a 38% chance that it will be called away. That is pretty high. But look at the premium, investors would pay me $130 for this call which is a 3.11% return just from the call. Hypothetically, if I were to sell that option repeatedly as it expires, that could add 37.83% of additional return. So I am getting a great return, but taking on a high risk of the stock getting called away.
If on the other hand, I choose a price that is further away from where AMAT trades, then I would see a higher probability that the call that I am selling won’t be exercised (POW). The tradeoff, however, is that the premium received ($43) is significantly less. This in turn makes the raw return (1.03%) shrink, and the annualized return (12.51%) also shrinks.
So ultimately, you as an investor have to weigh the risk of the asset being called away against the premium that you get. If you really like AMAT, you probably opt for Option 2. If you have already had a good run with AMAT and don’t mind losing it, you could choose Option 1.
A better model:
At Chaikin Analytics, we evaluate a stock’s trading range. By choosing a price that is at the upper band of the range, it allows us to profit as much as possible but leave the strike price outside of the normal trading range for the stock. This lets us lower the odds of the stock getting called (but also will allow us to profit more if it does). So, let’s go back to the AMAT example:
This chart shows the underlying stock Applied Materials (AMAT). The price is depicted by the blue bars, and the dashed line surrounding the price are the Chaikin Bands which gives a good picture of the trading range. Choosing a price around 45 would be at the upper band, and would provide a really good profit on any trade from where the stock is right now. Additionally, you get a reasonable return on the Call making it worthwhile.
If the stock did crest above $45, you would not only gain the $3.50 from where it is trading right now, but you would also get roughly $0.63 per share of premium for selling the call option. Not bad for a month.
On the other hand, if the stock isn’t called away, you still get the $0.63, and you get to start all over again, and sell another call option.
Choosing an Expiration Date:
Again, there is not a right answer. Just like choosing a strike price, you will face similar tradeoffs. If you choose an expiration date that is closer to current date, you will get less premium from selling the calls. On the other hand, it makes it less likely that the stock will be called away (all other factors equal) and it allows you to quickly repeat the process of selling calls again.
Let’s look at Cisco (CSCO). If I would choose a strike price at $57.50, and play with the dates, you can see the tradeoffs. If, for example, I choose end of May for this, I would get a premium of $30 (see below).
On the other hand, if I push the expiration out another few weeks, then I would get $56. This sounds like a good tradeoff on the surface, but it really isn’t. First it would increase the likelihood that CSCO goes on a run and the stock is called away. Note the lowered POW (price of expiring worthless). Additionally, I would have to wait until after June 21st to sell another call. This will diminish my annual return. In my books, I would rather have a tighter timeframe, get my smaller return, and then sell another call.
Choosing the right covered call to sell is really a personal choice, but it is important that you understand the tradeoffs. Ultimately, you should aim for the highest annualized return with a reasonable POW. By following this strategy, you can keep the stream of calls coming and keep collecting the income.