On occasion, I write covered calls to help boost the income of my portfolio. What is a covered call? At a high level, it’s allowing another investor (call buyer) the opportunity to purchase your shares (minimum 100 shares) at a certain price (strike price) and by a certain date (expiry).
Why would a covered call seller even consider the “option” for someone else to purchase their shares? Because they are paid to do so (called a premium)! For the buy and hold investor, writing a covered call is purely for the premium. The goal is for the option to expire without the shares being called away (ie. expire below the strike price) so that you can turn around and write another covered call. It can be a perpetual way to boost the returns from a stock holding providing that the stock does not get called away. As you play around with covered calls, you’ll notice that the higher the volatility of the stock, the higher the premiums will be as there is a higher likelihood of the stock price reaching the strike price.
As a dividend investor, I write covered calls on occasion to boost my monthly payout. I typically write them with about a one month expiry, but sometimes I get a bit greedy and accept a lower strike price in exchange for a higher premium. This means that the strike price has a higher probability to be hit, thus the stock being called/traded away.
When the stock price does go higher than the strike price, you have a few choices:
- Do Nothing. Wait for the expiry, and if the strike price is still higher, then the stock will most likely get called away (you’ll get charged a sell commission too).
- “Buy to close” the covered call position. If you do this, you will pay more to buy back the call option than the premium that you received. However, closing the call position allows you to continue riding the upside.
- Roll the Call. Here you buy back the call AND sell a new call higher than the current stock trading price. More details on this below.
Rolling the Covered Call
In the situation where the stock price is approaching or has exceeded the strike price, rolling the covered call may make sense. As mentioned, rolling a covered call is where you:
- Buy back (buy to close) your covered call position;
- Turn around and sell a new covered call at a higher strike price and collect a new premium.
In this scenario, the cost to buy back the call will be higher than the premium received. The difference is calculated as a capital loss. This hurts a little, but rolling the call helps ease the pain. One strategy is to pick an expiry that’s far enough out so that the new premium offsets the cost to close the call. Personally, I simply roll out the expiry another month at a higher strike price at a low probability of being hit.
A Real Life Example
I’m going to share with you an example of where writing a covered call may not have been the greatest of ideas, but rolling the call forward helped. In my U.S trading account, I hold a company called Ctrip.com (CTRP) which is like the Expedia of China purchased at $22.35.
The stock gapped up aggressively one May morning and I thought it was overdone, so I effectively shorted it by writing a June 22, 2013 expiry covered call at @$30 (trading at around $27 at the time) collecting $80USD in the process. Unfortunately, I was wrong, and the stock continued up to the $30 mark the same day! My instinct was that the stock was going to continue higher, so a couple weeks later I rolled the call forward. This is how I did it:
- I bought back the covered call for $230 USD (net loss $150 before commission)
- Sold a new covered call with same expiry date @ a strike price of $34 collecting a premium of $40 USD. This reduced the loss to $110 USD before commissions. However, if the stock gets called away @ $34, there is an additional $400 in capital gain.
Fortunately, the stock closed well below the strike price by the expiry date and the stock price has continued to drift upwards. I have since sold an August 41 call (August 17th expiry at a strike price of $41) for $65, so we’ll see how that goes! I’m making mistakes but slowly learning from them.
What is your experience with covered calls?
For more background information:
Disclaimer: This article is for informational purposes only. Options are extremely risky and should only be considered by highly experienced investors.If you would like to read more articles like this, you can sign up for my free weekly money tips newsletter below (we will never spam you).