In this report, we’re going to share one of the simplest investment techniques you should be considering for some of the stocks you own; one that is easy to understand and apply—yet can take a tremendous amount of risk off the table for your investments.
It’s one of the single best, and safest, income producing strategies you can use in the stock market, when you do it the right way.
It’s a strategy that you can consistently use to bring extra income into your investment accounts, or reduce your cost basis in the positions you own and lessen your risk and vulnerability to market drops. Plus, you don’t need your stock positions to go up in order to reap the benefits.
When done correctly, in our opinion, there’s no reason you can’t use this strategy we’re talking about here to safely generate an extra 15%+ annualized returns on your account. Best of all, you can use this technique in conjunction with buying some of the safest, high quality, well-managed companies—the best of the best companies we look to acquire.
All of these are bold claims that you might be skeptical of. So let’s dig in and explain why we believe they’re true.
The strategy that I’m talking about here is writing covered calls.
Before we get into the numbers and examples, let’s first talk about why this opportunity to reduce risk or add income to your investment accounts actually exists and is readily available in the real world.
It’s important to understand that the stock market is comprised of different types of people. These are people with various goals, strategies, techniques, or reasons for buying and selling shares of stock.
Some of these people are gamblers, or speculators—and there are lots of them when it comes to the stock market. Gamblers don’t care about a lot of the same things we do—strength of a company, cash-flow, great management, competitive advantage, or even price. To gamblers, none of that really matters. Instead, they view the stock market kind of like the world’s casino—a place they can speculate with relatively small amounts of money with the hope of hitting the big one or getting the big payout. One of the favored instruments for these gamblers is stock options.
Stock options are very misunderstood financial instruments. They get a bad name from the gamblers who use them for high leverage or for get-rich-quick-type, all or nothing trades. In fact, your financial advisor, major media, or even others around you might tell you that you’re crazy to even consider using stock options. That’s because of the few bad apples who use them to do dangerous things. Most people use options in a way which adds a great amount of risk to their capital, and they’re the ones you generally hear about when it comes to stock options.
We don’t use stock options in a dangerous or haphazard way. Instead, we reduce our risk and increase our returns by being on the other side of those speculators’ trades—collecting the money which they gamble away, and capping our risk in the process. We aren’t talking about trying to make 100% and 200% gains in one shot. Instead, we’re talking about owning great companies and earning small amounts of consistent, extra income from those stock positions.
First, the basics. Then we’ll use a real-life example to illustrate how this technique actually works.
A stock option is a simple contract between two parties that allows them to trade the right to buy or sell shares of stock.
There are two types of stock options you can use for various different strategies—call options and put options. Call options deal with buying a stock at a certain price in the future, whereas put options deal with selling a stock at a certain price in the future. In this report, we’ll only be talking about call options—more specifically, selling call options.
Here’s how it works…
Remember that there are two parties to each call option trade. There’s the buyer of the call option, and on the other side there will always be a seller of the call option.
When you buy a call option, you are purchasing the right, but not the obligation, to buy a particular stock, at an agreed-upon price, at a specific time in the future.
When you sell a call option, you are taking the other side of that trade, and you get paid for agreeing to take on the obligation to sell a particular stock, at an agreed-upon price, at a specific time in the future.
The covered call strategy that we want to explain here works by owning shares of some of our favorite companies, then selling calls at price agreements higher than the current market price of the stock.
The best way to really understand how writing covered call options works is by diving right into an example.
Let’s look at Nike (NKE).
Nike is a global giant in the athletic gear industry, with an $85-billion-dollar enterprise value. They have a dominant market share in their industry and have been a safe, cash-producing, dividend-paying company with a relatively low degree of volatility over the years. It’s an elite company, with an elite brand, and a huge competitive advantage that is able to attract the top athletes in the world—like Michael Jordan, Tiger Woods and Lebron James, to use and promote their products. It’s been a wonderful company to own for many years.
In October, Nike was trading for about $51/share. This was a fair price, at an enterprise multiple of 18. Buying at these levels would likely yield pretty good returns over the long-run. Not necessarily a wonderful bargain, but a pretty fair price for Nike. So let’s assume you buy 100 shares of Nike stock at $51—for a total investment of $5,100.
Now imagine that a short-term trader calls you up and says that he thinks Nike could stage a big price rally over the next three months or so. This trader says that he would like to buy your 100 shares of Nike for $52.50, a bit over the current price of $51.
Well why would he want to pay you more than the current market price? Here’s where a call option comes in…
He says that he doesn’t want to pay you for those shares right now, but rather, he might want to in about three months. He goes on to say that if you agree to sell him your shares of Nike at $52.50, in a little over three months, then he’ll pay you $250 right now, and another $5,250 in January, if he decides to buy your shares.
In other words, this trader will pay you $250 in cash, immediately, if you agree to sell him your 100-share stake in Nike at $52.50/share ($1.50/share over the current market price) in about three months.
What he’s talking about is buying a call option, which is an option to buy your 100 shares of Nike in about three months at $52.50 per share. He’s paying you $250 to purchase that call option. You would be selling the call option (also referred to as writing a call option), which means you agree to sell 100 shares of Nike at $52.50 per share in about three months. You collect $250 by taking on that responsibility.
This $250 cash payment you receive would be a 4.9% yield on your original $5,100 investment, and this agreement would last for just over three months.
Would you do it?
Well let’s consider the four possible scenarios...
Nike shares could move up past $52.50 when your agreement expires in January. In this case, you would be obligated to sell your shares to the trader for a total of $5,250, a small gain on your original investment of $5,100, and you keep the $250 cash. On top of that, you collect the dividend of $0.16 per share in January—or another $16. All said, in this scenario, you would make about an 8.2% return on your original $5,100 investment in just over three months, or about 31% annualized. Not a bad way to go.
Nike shares could move up past $51, but not past $52.50 when your agreement expires in January.
Nike shares could just stumble around and stay flat around the $51 price, by time your agreement expires in January.
Nike’s shares could drop below $51 by time your agreement expires in January.
In the second, third, and fourth scenarios, the end result would essentially be the same.
In each of those three cases, the trader you made the deal with would not want to buy your shares for $52.50, since he could pay less than that on the open market. So your agreement would expire worthless, but you would still keep the $250 upfront cash payment, plus the $16 dividend, and would no longer be on the hook for selling your shares. In scenarios two, three and four, you’d collect about a 5.2% return on your original investment in just over three months, or about 20% annualized. Plus, you would still own the stock. This is also not a bad way to go.
Another way to look at the outcome in the second, third or fourth scenarios, in lieu of getting the 20% annualized return, is that your effective basis in Nike’s stock is reduced by the amount received for selling the call—$250. So while you paid $5,100 originally for your 100 shares, you’ve since collected $250 for the call, plus $16 for the dividend, for a total reduction of $266. Subtracting this from the original $5,100 investment gives you a total investment of $4,834—or $48.34/share. This is your effective basis in Nike now, meaning that even if Nike’s price dropped during these three months, you could still be profitable above $48.34/share. This is another way as to how writing covered call options helps to reduce any loss due to stock price drops.
Note that you can’t have it both ways in scenarios two, three and four. You cannot get both the 20% annualized return as income, while also effectively reducing your basis. It’s an either/or prospect. Either you attribute the 20% annualized return as income received, or you attribute it toward reducing your basis in the stock.
Luckily, you don’t need to wait for short-term traders, or gamblers, to call you up and offer you the types of deals in our example in order to make this work. Once again, the technique I just described is called writing covered calls. It works by owning a stock, and selling a call option on the stock above the current market price. And these deals that the trader made with us are readily available every day in the options market on most any company stock, through your brokerage account. There are always many willing buyers of call options just like in the example, who will pay us to sell them our shares for a profit.
It’s important to note that whichever scenario happens shouldn’t really matter to you. This is a win for you no matter which way Nike’s stock moves. If the stock does not move up above $52.50/share (scenarios #2, #3, and #4), you keep your shares, collect your 5.2% return over three months in the process, and you can do a similar trade once again. Or, the stock does move up past $52.50/share (scenario #1), you book your 8.2% gain in three months, and you can buy more shares, either on Nike or another company, to do the deal over again. If you make this same type of trade 3-4 times per year on your margin of safety companies, you could collect 15%-25% annualized returns on your investments, no matter which way the price moves. And you do this by simply owning them and making similar agreements to sell at some higher price in the future. Those returns are nothing to yawn at; and the process is relatively simple.
It’s how our strategy works; people pay us upfront cash for agreeing to sell them our stocks for a profit. Either the stocks go up past our agreement price, and we sell them; or they don’t move past our agreement price, and we keep them. Either way we collect money. These 5%-8% returns add up very quickly, and are an amazing way (in our opinion) to reduce your risk and generate some returns from your stock holdings.
Note: It’s possible the trader would like you to sell him your Nike shares at $52.50, before the three months are up. For instance, if the price of Nike moves up in one month past $52.50, you may be forced to sell your shares if the buyer of the call wants you to do so. In that case, your return is the same, you just did it much more quickly—meaning the annualized return would increase. This is very rare, however, and most call options are held until the expiration date.
Also note: that Nike options trade is strictly for educational purposes and not a recommended trade. Stock and options prices move by the minute, and the numbers will likely be much different by time you see it.
Covering Your Risk
An important component of writing covered call options is the “covered” portion. Covered means that your risk is capped. You “cover” the call option by owning shares of the stock to begin with.
Let’s go back to the Nike example and assume you forgot about the whole “covered” component.
Let’s say you sell the same call. So you’d be obligated to sell 100 shares of Nike at $52.50 about three months from now, and you’d collect $250 in cash up front. Only this time, you don’t own Nike shares to begin with. This changes everything as far as your risk goes.
Consider the four scenarios now.
The second, third and fourth scenario stay essentially the same. If Nike shares don’t move up past $52.50, then you get to keep your $250, and you’re free and clear with no further obligation. The only difference is you didn’t collect the $16 dividend since you didn’t own the shares.
However, the first scenario from before is where things can get ugly. It’s just one of the reasons options get a bad name. If Nike shares do trade up above $52.50, then you start losing money for every penny it moves up. Since selling the call option obligates you to sell 100 shares of Nike at $52.50, you must fulfill that obligation no matter what. What happens if Nike trades up to $70/share? Since you don’t have the shares to hand over to the buyer of the call, you’d have to make up the difference in cash, for a total of $1,750.
What happens if Nike trades up to $90/share? Once again, since you don’t have the shares to hand over to the buyer of the call, you’d have to make up the difference in cash, for a total of $3,750. Of course, you already received $250—or $2.50/share. So the point at which you would truly start to lose money on this trade is $52.50 + $2.50, or $55/share. Each penny Nike moves up above that break-even level of $55/share is another $1 out of your pocket.
This is referred to as naked call writing—and it’s extremely risky. The maximum gain is $250, the original amount you were paid; while the maximum loss goes to infinity, since there is theoretically no upper limit to how far Nike’s stock price can rise. You should never do this.
Instead, we cap our risk by covering the call. We cover the call by owning the shares of stock to begin with. This way, any upward movement in price past $52.50 is covered by our shares. Nothing complicated or risky about it. This is a simple approach that can be used on your margin of safety investments.
Who Buys the Call From Us?
Take note of what we’re doing here. There are many reasons as to why people might buy calls. It’s not always the gambler-type who is on the buy-side of the calls and is looking to hit the big jackpot. Maybe the buyer is trying to hedge an unrelated trade. Or maybe the buyer isn’t willing to pay the full amount for the stock, so chooses to use the options market instead. The point is, there are many different reasons and motivations for buying calls. And we never know who the buyer is on the other side of the call we sell, or what their motivation for buying the call is. It doesn’t matter to us—at the right price, we’ll sell them calls on our stocks no matter what their reasons for buying them are.
For simplicity sake, we picture it as a gambler looking to hit the big jackpot, buying our calls on the other end. The way we think of it, we’re selling lottery tickets to stock market speculators when we write covered calls.
Think about it from the call buyer’s perspective—the trader who proposed buying our Nike shares at $52.50. He could have just bought the 100 shares on the open market and reaped the benefits of the price going up. But he either didn’t want to risk the full $5,100, or he wanted to leverage his returns. Instead of buying shares, he paid just $250 for the call, and was still able to participate in upward gains of Nike’s stock—similar to if he simply bought and owned the shares. It’s a lottery ticket, because he pays a relatively small amount, while having the potential for a nice gain. If Nike moved to $70, his $250 gamble would have paid him $1,750. That’s quite the ROI.
However, this gamble has to move in the right direction within the time span of the option—in our trader’s case, just over three months. While owning a stock, we have all the time we need for the price to move up; the owner of a call needs things to happen very quickly. This call has time working against it—since it will expire worthless if Nike does not move past $52.50 within three months. It loses value every day, since each day equates to less time for the stock to move up. Since he paid $2.50/share for the call option, and the option isn’t profitable until Nike goes above $52.50/share, our trader has a break-even price of $55/share. He needs Nike to move from $51 to $55, within about three months, before he starts to see a penny of profit. Just like a casino, the odds start to stack up against the buyers of these calls relatively quickly, because everything has to go just right in order for them to be profitable.
This is why we prefer to be on the sell-side of these lottery tickets, because we get to consistently collect our 5% and 6%+ gains, and yet we never actually have to make the big payout if the gambler is right—we simply hand over our shares in the company, if need be, then turn around and do this all over again.
Writing covered calls is not a sexy strategy—and that’s why you don’t see as many people writing covered calls as you do buying calls or using options in a more exciting way. Many people like gambling or trying to hit it big in the options market—that’s not what we’re doing here. You aren’t going to be at a dinner party, bragging about your latest 5% covered call trade on Nike. But you know what? Doing this consistently, over and over again, on some of the safest and best stocks available can yield some pretty amazing annualized returns for you over time—in such a simple way. We aren’t trying to be flashy with this strategy—we’re just trying to make money. Plain and simple. We don’t need to brag. We just want to create a consistent income, own the best stocks we can find, and reduce our risk as much as possible. We can do more exciting things or make potentially higher profit moves on the 10%-20% of our portfolio reserved for special ops, speculative positions—there’s nothing wrong with that. But that’s not what writing covered calls is for.
Call Options Glossary
Before you are off and running with writing covered calls, you should understand some key words and lingo used in the options market.
The agreement between the buyer and the seller of the call option is called a “contract”. One contract controls 100 shares at a time. So remember that you can only sell covered call options when you own at least 100 shares of stock in a company. Being the seller of one call contract means you are on the hook for selling 100 shares, and selling two contracts means you are on the hook for selling 200 shares. There is no in-between number of shares available in the options market.
The date the call option is good through is called the “expiration date”. Most options contracts will expire on the third Friday of the month. In our example, January 20th was the expiration date that the call option was good through—January 20th was the third Friday of that month.
The money that you receive for making the agreement in a call option is called the “option premium”. We received $2.50/share in “option premium” for agreeing to sell Nike at $52.50/share.
The “underlying asset” is the stock you are dealing with. In the example, the underlying asset is Nike. All options are contracts on underlying assets—without the asset, or stock, there would be no option contract.
The price that you are agreeing to sell shares at when selling a call option is called the “strike price”. This was $52.50/share in our Nike example. It’s the price—based on the underlying asset, Nike, at which the option can be “exercised”. You can deal in many different strike prices; you need to be able to choose at which price you are willing to sell, and what you are willing to receive in order to take on that responsibility.
When the price of the underlying asset, Nike, is above the strike price, the call option is said to be “in the money”. If Nike were to trade at $54/share, the call would be “in the money”. It’s from the viewpoint of the buyer of the call; as Nike trades above the strike price, then the call can be exercised by the buyer at a profit. Since you are the call-seller in this strategy, any time the option is in the money, you are potentially on the hook for selling the stock at the strike price—$52.50, no matter how high the market price is.
When the price of the underlying asset, Nike, is identical to the strike price, the call is said to be “at the money”.
When the price of the underlying asset, Nike, is below the strike price, the call is said to be “out of the money”. With Nike at $51, the call would be “out of the money”. It’s from the viewpoint of the buyer of the call; as Nike trades below the strike price, then the call cannot be exercised at a profit, so it’s out of the money for the call-buyer. Since you are the call-seller in this strategy, if the option expires out of the money, below the strike price, then you keep the option premium with no further responsibility.
Key Factors that Determine the Price of Call Options
Distance Between the Strike Price and the Market Price:
We look to sell out of the money call options on the best companies to safely reduce risk and generate returns. One of the most important factors as to how much premium (and % return) we can get is how close the strike price is to the current market price. For calls, the lower the strike price relative to the market price, the greater premium we’ll receive. With Nike’s stock at $51/share, we would be able to get a larger premium for the $52.50 strike price than the $55 strike price. Similarly, we can get a larger premium on the $55 strike price than we could on the $60 strike price. This is because the likelihood of the call option expiring in the money for the buyer of the call goes down as we get higher up on the strike price, and further out of the money. If the strike price is very close to the market price, the likelihood of the call-buyer being profitable goes up, so the premium will cost more. The call buyer must pay for that increased likelihood of being profitable. If the strike price is higher, and further out of the money, the likelihood of the call-buyer being profitable goes down, so the premium will be less money to take that decreased likelihood of a payoff into account.
Time Until Expiration:
The longer period an option has to move, the more expensive it will be. Very simple. A one-month option has less time to move, and fewer catalysts for movement, than a one-year option. So all else equal, that one-month option will cost significantly less than the one-year option, in order to take that extra time for movement into account. Extra time simply gives the stock more time to make the move up in price for the call-buyer. An option is known as a “wasting asset”, because it will eventually expire and not be worth anything. It loses value each day with the passage of time; so more time remaining equals a higher premium. This is why we like primarily selling options—time works for us, not against us.
The more volatile the stock, the more expensive the call option will be. This is true, even if the stock is only perceived to be more volatile. This is a huge factor. Since volatile stocks have a much higher potential for large price swings, there’s a higher probability that an out of the money call option can make the move up to being in the money. This is why the premiums are higher for potentially volatile stocks. Think of it like car insurance: high-risk drivers cost more to insure because the likelihood of a payout is increased; whereas low-risk drivers cost much less to insure because the likelihood of a payout is decreased.
Managing Your Risk
This is undoubtedly a powerful strategy to have in your investment arsenal, but you’re probably wondering where the catch is, or how you decide where and when to execute the strategy.
Well there’s one fairly obvious downside, or catch to writing covered calls: you could potentially miss out on big gains from upward movement in the stock you own.
It’s what the buyer of the call option is paying for—he’s gambling that the price will move up, big, relatively quickly.
Continuing with our example, if Nike stock moves from $51 per share up to $70 per share in the three months after you sell the call, then you only get to participate in the gains up to $52.50 per share, plus the $2.50 per share you received for selling the call. The additional $17.50/share (minus the 2.50/share paid for the call) goes to the buyer of the call option instead of you. These are gains that could have been yours as a shareholder in Nike’s stock, but because you wrote a covered call, you don’t get to see them.
That’s the risk with writing covered calls, but it’s one we’ll happily take when we can utilize this strategy to safely pull in 15%-25% annualized returns on our stock holdings. We handle this risk of covered call writing in three ways…
First, we always write calls on our stocks at strike prices that are above the current market price—on out of the money calls. This way, on top of the premium received, we also lock in gains on the stock if the price does rise. The only time we will end up selling in this case, is if it’s for a profit. If the stock does not go up and expire in the money, then we get to keep our premium and effectively lower our basis in the stock by the amount received, or simply collect it as income. This helps reduce our risk and offset any future price drops. Then, we might turn around and sell another call to collect more premium.
Take our Nike example—there’s nothing to complain about if the price moves up and we lock in 8% returns in just over three months. We received about 5% in call premium and another 3% in price appreciation. That’s a 31% annualized return. Sure, it hurts to miss out on extra potential price moves if Nike soars, but that’s a decision we need to be comfortable with before selling the call. That’s where the next part comes in…
Second, we don’t write covered calls when a stock is extremely cheap, or selling for deep discounts to their intrinsic value. For example, 2009 would have been a terrible time to be writing covered calls on stock holdings, because stocks we’re selling for very low multiples of earnings. The potential for price rebounds was very high, and writing covered calls would have eliminated a huge part of that upside.
The best times to be selling covered calls are when stocks are selling for fair to high prices relative to their value.
Thinking about our Nike example once again, $51 is not an extremely cheap price for Nike. It’s a fair price for a wonderful company, but an 18 enterprise multiple is certainly not a deep, margin of safety price. For that reason, it’s a perfect time to write a covered call. We don’t expect huge movement upward in price at these levels, and even if we get it, we are perfectly happy being “forced” to lock in gains, collect some premium, and sell Nike for a profit. If the price, instead, moves down—then the $250 we received in call premium will help to offset the price drop, at which time we can sell another call to effectively lower our basis or collect additional income.
We like owning a stock such as Nike at these levels, because it’s a company we love and feel comfortable holding on to; yet at current prices, can comfortably write covered calls and collect income when the opportunity for big-time price appreciation is not as high as it has been in the past.
The question to ask yourself is, “will I be comfortable selling this stock for a profit at the strike price?” If the strike price is at a level which you feel is greatly undervalued, don’t do it. In that case, hang on to the stock to participate in upward gains in the stock price. If the strike price is at a level where you calculate it to be a fair price, but not necessarily a great one, then the covered call writing strategy can be a great choice to generate income from your stock holdings, and reduce the risk of a price drop.
Finally, the third way we handle the opportunity cost, or risk, of potentially missing out on gains by selling covered calls is to demand a minimum acceptable return.
You don’t want to just write any covered call without getting adequately paid for your agreement to sell the stock at the strike price. The minimum acceptable return is what we use to determine if a particular call is worth writing on one of our stock holdings—if the return we’ll get immediately is worth the opportunity cost of missing out on potential gains. Your minimum acceptable return might differ from ours. It’s your choice what you want to accept, and it really depends on what your other choices for investment are. We try to get at least a 12% annualized return on all of our covered call contracts. If we can’t get at least a 12% annualized return, then we typically decide it’s not worth the risk—or the opportunity cost of not being able to participate in price gains beyond the strike price for the life of the call.
Here’s how we calculate the anticipated return for covered call options, to see if it meets our minimum acceptable return …
First off, we base this return on the assumption that our stock price will not end up above the strike price of the call. This is the lowest possible return we can get by writing the covered call option. If the stock price goes above the strike price, then we know that we’ll make some extra amount in gains between the market price and the strike price—this is why we sell out of the money calls, above the current market price.
Let’s go back to the Nike example.
The price of Nike’s stock was $51/share, at the time we wanted to write the call. We were able to get $2.50/share in call premium if we wanted to sell the $52.50 strike price with a January expiration.
The return can be calculated by diving the $2.50/share received by the current price of $51/share. This comes out to 4.9%. That’s the immediate return you receive off the current price.
But you only have this commitment to sell your Nike shares at the strike price of $52.50 for just over three months—95 days to be exact, in our example. So we need to annualize it. To annualize it, we take the 4.9% return and divide it by the number of days remaining until the expiration of the call option—95 days. Then we multiply it by the total number of days in a year—365. This annualizes the return and comes out to 18.8%. This is well beyond our minimum acceptable return, at a strike price above the current market price, and at a strike price we would feel comfortable selling, so it passes. We use this calculation as the minimum acceptable return base, since selling shares at the strike price (a higher price than the market) if the stock goes up will guarantee even greater returns.
Also, you should be mindful of transaction costs included with your brokerage account. If it costs $10 in commission costs per option trade with your brokerage, then you need to deduct that from your option premium profit. You’ll certainly want to make enough after accounting for commission costs to still fulfill your minimum acceptable return percentage.
In summary, there are great times to be a covered call writer, and there are not so great times. Knowing the difference, and following those three rules to manage your risk is the key to recognizing when the best times are to execute the strategy.
As a side note—we generally like to sell covered calls that expire in the next 40-90 days. Of course, there are exceptions depending on the goal and your desired payout, but this duration generally seems to be where we execute most of our covered call writing. Given the way options are priced, you can generally get higher option premiums relative to the risk or obligation involved by zeroing in on this duration. This allows you to executive this type of trade, and collect multiple option premiums throughout the year—as opposed to doing one or two covered calls over the year which expire in six to twelve months. The result at the end of a year is typically higher returns.
So there you have it—the basics of writing covered calls. As you can see, it’s a powerful strategy to apply; and once you wrap your head around the concept, it’s a fairly simple strategy to understand and use with your investments. Remember that options get a bad name because of the people who use them to add risk; we’re using them in a way which decreases risk, and a way in which we can supercharge our investment results in a big way.
If you’re just starting out, I suggest beginning with small amounts, or even paper trading on a practice account to see how option prices move and behave. Be sure to click around or ask questions with your broker to see how you go about executing these type of trades; and before investing any money, make sure you thoroughly understand how your broker’s trading platform works.
Good luck and good investing.