The Laptop Investor

When it comes to options strategies, the most common and widespread strategy is “Writing Covered Calls.” This is an excellent strategy and the extra income gained from this strategy can have you beating the market.

This is an easy strategy to adopt and there are a wealth of so called gurus offering courses, seminars and workshops on how to do this. Sadly many are just there to profit from the students and I say that as I’m amazed at how a course on this topic can cost literally thousands of dollars for information that is rudimentary and can be sourced publicly for free.

So how does writing covered calls work. In my previous article Stock Options I actually used the strategy without defining it as such so I will clarify it here. Essentially while owning stocks in your portfolio you write a call option and earn an income from that option. Now writing and selling in the option world is pretty much the same thing except writing means you sell to open an option contract or in other words you create an option contract and add an additional option contract to the market.

When I first studied call writing in class this concept of “writing” had people confused. In simple terms on your brokerage platform you hit the sell button and not the buy and when you do that you create a new option contract on the open market.

So this strategy can be done on your existing portfolio or you can start this strategy outright on shares by buying shares in lots of 100 as each option contract controls 100 shares. Then from that you can sell an option contract on your existing shares.

I mentioned this strategy can beat the market as the share portfolio that underpins this strategy essentially is the market and will follow the market, however this depends how closely it is correlated with the market, ie whether you’re correlated with the S&P500 or another index and in fact you may choose to invest in an index ETF and write covered calls just on that. So the point being is the shares will follow the market and the call writing will earn additional monthly premium on top of what the shares do and any dividends received by the stock owned.

There must be a catch right? Well yes to an extent, and when we write covered calls that are ‘Out of the Money’ what we are doing is earning premium and giving up the upside capital potential above the strike price of the call option sold.

So for this example I will use the McDonalds covered call I did in my previous article.
I purchased 100 McDonalds shares trading at $137.30 which cost me $13730 and I sold a call option at the 160 strike for $4.75 per share (total earning of $475) with the expiry a month away.

So let’s break this down, I outlaid $13730 to buy 100 McDonalds shares and by writing the covered call I earned $475. So in addition to any dividends or capital growth on the shares I made 3.5%.

So not only am I earning an income from the shares I wanted to own anyway, I am also by earning the income reducing my cost basis of the shares should a negative market event occur. What I mean by this is I purchased the shares for $137.30 yet earned $4.75 per share via the call option. So my cost basis is now $132.55 (137.30 – 4.75). I can keep doing this every month earning an income and reducing my share cost basis.

The reason this is called “covered” call writing is when you sell the call option, it’s covered (or backed) by the shares I own. As mentioned we sold the call option at the 160 strike which means if the share price rises above 160 the call option will become ‘In the Money’ and develop what’s called Intrinsic Value. So essentially the call option will increase in value for the buyer and he is earning capital growth, however this is offset by the capital growth we have in our shares so we are covered when it comes to option expiry.

What is ideal is to sell call options that expire worthless however no one can predict the market that accurately and this is a lesson in itself which is “Strike Selection” and one of the factors we take on board when writing monthly calls.

So as I mentioned earlier this strategy can beat the market, and I showed how in this example 3% was made for the month and imagine now doing this for a whole year and that potentially is 36% annualized and a return that’s on top of the market moves. Note that at the time of writing option premiums due to heightened volatility is on the higher side than normal, however covered call writing can definitely earn you 20 – 30% a year (on top of capital growth and dividend returns).

So as you can see this strategy in itself is quite impressive and is a slightly bullish strategy. There are other factors to take into consideration, ie if the market drops significantly and even if the market rises significantly. One thing we don’t want to do is write a call option below our share cost basis, ie if the market dropped significantly.

So earning 20% or more a year is nothing to be sneezed at and it is comforting for a lot to know they will make money regardless of market conditions. The downside to this strategy is that it’s capital intensive however from a return on investment point of view it can yield excellent results as can be seen.  Considering any portfolio should be diversified, the capital required can inhibit that for most people. There are some methods where less capital can be outlaid which increase the overall returns and allow funds to spread further. For example it’s possible to earn 5 to 10 times the monthly income on the capital engaged. This would translate to 15 to 30% per month. However this is an advanced strategy and the risk in my opinion outweighs the reward and I would only ever delve into this with the most seasoned, leveled and experienced traders.