Covered Call for Income
Professional investment advice on the options covered call investment strategy, which aims to generate additional monthly income on top of dividends.
A low interest rate environment prompts investors to search for alternative forms of yield from their investment strategies. If you are looking for an investment strategy to help generate additional income on top of your dividends with existing or new stock, you can take advantage of a relatively low risk strategy named a covered call.
What is a covered call?
A covered call is an investment strategy which can help produce a monthly income where you sell (write) a call option against existing shares. In Australia, 1 equity option contract equals 100 shares so you would sell 1 contract per 100 shares that you are allocating to the covered call strategy. In exchange for selling the call, you will collect a premium from the option buyer. However, the option premium comes with an obligation; if the buyer exercises the option, you will be obligated to deliver the underlying shares (sell the shares) to the buyer of the option at the sold strike price.
As you already own the stock, you are "covered" and can deliver the underlying shares, hence the name of the strategy, covered call.
Why write covered calls?
When you are selling a covered call, the goal is to generate extra premium income whilst keeping the underlying stock. Ideally the strategy is implemented when the view is for the stock to move sideways or down and stay below the strike price of the sold call resulting in the option position to expire worthless. In this instance you keep the option premium as well as the stock; thereby generating an additional income on your existing holding.
This strategy is particularly good for stocks that pay stable dividends and enjoy a relatively stable stock price such as the major banks (CBA, ANZ, NAB, WBC), miners (BHP, RIO) and consumer staples (WES, WOW).
A covered call example
Let's say for example you own 1,000 shares of Stock XYZ. You purchased the stock for $50 and XYZ is now trading at $80; you don't think it will rise any further in the short term. You are comfortable with selling the stock at the current levels but prefer to try and earn extra income while the stock goes sideways. You consider selling a call option over your existing shares, weighing up the potential premium earned and your short term view against the risk of having to sell your shares if exercised.
In January, you sell 10 XYZ February covered call contracts at a strike price of $82 for $1 per contract. You will receive option premium of $1,000 ($1 x 10 x 100) credited to your ledger or cash management account, less brokerage. This cash deposit is yours to keep.
If XYZ stays below $82 at expiry in February, you keep the $1,000 option premium and continue to hold the stock. You have just earned an extra $1,000 on your existing stock that you otherwise would not. Keep in mind that as long as the stock stays below the sold strike price, you will not lose your stock. You can repeat the process for the next month if you believe the strategy is still relevant based on your outlook for the stock price. If XYZ trades above $82 before expiry, you may be obligated to sell the shares for $82 regardless of how high the underlying price of the shares trade.
What if I don't want to sell the stock?
Many of our clients do not want to give up the stock due to large capital gains which would trigger a CGT event if sold. Although this risk cannot be completely eliminated and the risk of losing the stock must be weighed against the potential premium that can be earned there are ways to reduce the risk of getting called:
- Sell European style options. Unlike American options, European style options cannot be exercised until the last day of expiry. This allows the opportunity to "roll" the option forward or close the option before expiry to avoid exercise.
- Roll the option forward. Simultaneously buying back the existing contract and selling a European option further out in time. Rolling out in time or up to a higher strike gives the opportunity for the stock to pull back below the sold strike price. However does not remove the obligation to sell the shares until the option has expired worthless.
- Close the option position for a loss prior to expiry, removing the obligation to sell the shares.
- Selling after a market rally or indication of potential weakness in an attempt to better time the sale of the option and potentially reduce the probability of the stock getting called away.
- Selling further "out of the money". By selling the option much further above the current stock price you will reduce the risk of exercise and increase capital gain potential, however the trade off is that you will receive less option premium for selling the call.
The risk of losing the stock is always there but with our expert investment advice, we can assist to reduce this risk.
What are the risks in covered call writing?
Covered call writing is generally considered to be a fairly conservative options strategy.
- Downside risk as a stockholder. As a stockholder, you are exposed to potential losses by holding the underlying stock. However, if you are a long term holder, you already understand the risk of holding shares and there is no additional downside. In fact, the sold premium helps cushion market falls by generating an additional income when the stock moves sideways.
- Limited upside. As a pure stockholder, you have unlimited upside potential for the stock. Once you write a covered call, you are effectively limiting your upside potential. In effect, you are selling your upside potential for a premium and may be obligated to sell or deliver your shares to the option buyer.
Covered Call Guide
If you want to take advantage of this low risk strategy and give your income stream a boost, contact one of our friendly, experienced and fully accredited options advisors.