Covered Calls Offer High Yields but Limit Gains

 In Investments, Stocks

The Federal Reserve has promised to keep short-term interest rates low until at least 2015. Therefore, investors have scant hope that bank accounts, money market funds, or high-quality bonds will soon offer higher yields.

Investors who seek significant current cash flow might consider selling so-called “covered calls” on stocks they own. Investors can trade listed options on many stocks and exchange- traded funds. For example, you can buy or sell put or call options on stocks issued by companies such as Apple, Bank of America, and Intel. The owner of a call option has the opportunity to buy, while the owner of a put option has the opportunity to sell the underlying security. For increased cash flow, you can sell (“write,” as options traders say) one of these options and collect an upfront premium payment.

Example 1: Meg Lawson thinks that ABC Corp.’s stock will not go up much in the near future but also will not drop by much. Rather than put $2,000 into a money market fund, she uses that money to buy 100 shares of ABC trading at $20.

To implement a “buy-write” strategy, Meg then sells one call on ABC (a call option covers 100 shares). Meg chooses to sell an option that will expire in three months, with a $22 “strike” (purchase) price. This option is listed at 50 cents, meaning that Meg will receive $50 for selling the call: 50 cents times 100 shares. The option Meg has sold is a “covered” call because she owns the shares to meet any exercise of this option.

Possible outcomes
Suppose the three months pass, and ABC’s stock has traded between $19 and $21. The call option will expire—the owner of the option won’t exercise the right to buy at $22 a share. Meg has received a 2.5% return on her investment ($50/$2,000) in three months, for a 10% annualized return. She’ll also collect any dividend ABC has paid in those three months, boosting her return. (This simplified example ignores Meg’s trading costs.) If Meg wishes, she can keep selling calls and keep collecting option premiums.

Example 2: Meg sells a three- month, $22 covered call on ABC, as described. Here, ABC goes up to $25 a share within three months. Thus, the owner of the call exercises the option, buying Meg’s 100 shares for $22 apiece. Meg has a 10% profit on the stock (bought for $2,000, sold for $2,200) in addition to the option premium she collected plus any dividends.

Tracking the tradeoff
From the examples in this article, you can see both the pros and cons of covered calls. Selling these options offers you a way to increase your investment income. If you sell options with a strike price higher than the trading price (an “out of the money” call), you’ll retain some opportunity to profit, if the shares are called away.

However, in our example, Meg has capped her profit at $2 per share. If ABC keeps climbing past $25 to $30 or $35 a share, Meg won’t participate in those gains. It’s true that Meg can buy back the call and keep her ABC shares. She’ll take a loss on the option trades, though.

What’s more, Meg has no guarantee that her ABC shares will stay flat or rise. If the price drops, and Meg sees her $2,000 investment fall to $1,800, $1,600, or lower, her $50 option premium won’t offset her loss.

Thus, selling covered calls won’t guarantee superior investment results. That said, this strategy can be useful to stock market investors who fully understand the risks and potential benefits. With yields at historic low levels and the likelihood of staying that way for a while, you may find it worthwhile to investigate this technique.