Are your top three investing goals capital preservation, to generate income and growth – in that order?
Well, look no further than covered calls, the investment strategy that allows you to take a conservative stance using options and sleep well at night. I can’t emphasize enough how important it is for all self-directed investors to take a serious look at this strategy.
Definition: A covered call combines a short (sold) call with stock ownership, so that the premium from the call reduces the cost basis of the stock and limits the potential gain of the trade.
While the above definition is correct, it makes my eyes roll when I read it. It is the type of industry jargon that keeps self-directed investors at bay. But don’t be scared.
Simply stated, a covered-call strategy limits your short-term gain and reduces your cost basis … forever.
Again, your short-term gain is limited, but your long-term cost basis is reduced forever. If you can buy something for less than what it currently trades for and do that in perpetuity, then … well … why wouldn’t you?
What do you need to initiate the strategy? One hundred shares of stock and a liquid options market. By liquid, I mean options that are more heavily traded and that have narrow bid-ask spreads.
If you own at least 100 shares of stock, then you have the ability to “sell a call” against your stock (assuming it has options, which most do).
Remember, 100 shares of stock = 1 option contract.
When is the preferred time to implement the strategy? In general, you want to sell covered calls when stock prices are low (toward the bottom of a range) and implied volatility is high. This scenario generates a higher-than- normal return on the proceeds of the call.
But remember, our No. 1 goal is capital preservation so we want to maintain a conservative strategy. We accomplish this goal by simply sticking with lower-beta stocks like those found in the Dow Jones Industrial Average ETF (NYSE: DIA).
The following stocks represent good candidates:
1. American Express (NYSE:AXP)
2. Caterpillar (NYSE:CAT)
3. Chevron (NYSE: CVX)
4. Exxon Mobil (NYSE: XOM)
5. Home Depot (NYSE: HD)
6. Intel (NASDAQ: INTC)
7. International Business Machines (NYSE: IBM)
8. McDonald’s (NYSE: MCD)
9. Wal-Mart (NYSE: WMT)
Now let’s create the scenario.
You inherited 500 shares of Intel (NYSE: INTC) from your father several years ago and have since worked hard to purchase an additional 500 shares. Your father believed in the long-term prospects of the company and you do as well. You have no intention of selling the stock any time soon – it’s a long-term investment.
Intel has recently experienced a sharp pullback, so implied volatility – and thus, option premium – is higher than normal.
As a result, you wish to take advantage of the increased options prices by selling a few covered calls, thereby reducing your long-term cost basis … which is the ultimate goal of a covered-call options strategy.
Your average purchase price is $23.00. For simplicity’s sake we will say that INTC is currently trading at $26.00.
With an implied volatility of approximately 31%, you can go two strikes out of the money (28 strike) for roughly $0.40.
What does that mean?
It means that every 60 days we are able to potentially collect $400 against our 1000 shares of Intel. Annually that equates to approximately $2,400 of income, but more importantly it lowers the long-term cost basis to $20.60 a share. Not bad.
The above scenario is best case. Two strikes out in Intel offers an 80% chance of success (that the option will expire out of the money, or worthless), so you should expect that not every month will be successful. It’s okay. Remember, you are going to own this stock for the long term. Any reduction of your cost basis is a step in the right direction.
I will be going over the fine details of covered calls and various ways to use the strategy in future articles. Stay tuned.
As always, please do not hesitate to email me with any questions or comments.
Editor and Chief Options Strategist