The Quest for Yield (Part 4): Covered Writes, The Single Best Method for Generating Income

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 |  Includes: DIA, QQQ, SPY
by: Jeff Miller

Many yield-oriented investors miss out on one of the single best methods for generating income: Selling calls against their stock positions.

Options trading can be frightening for beginners. After the 1987 market crash, the rules about disclosure and suitability were tightened up. To qualify for options trading the investor must demonstrate some knowledge and experience. These rules are good, but a little study can give you the knowledge and confidence you need.

This article describes how a covered write strategy, selling calls against stock positions, fits into a total return portfolio with an emphasis on retirement needs. It is the fourth installment of my "Yield Quest" series.

My approach is a bit different from most authors emphasizing income investments. I believe that fear has created an over-emphasis on fixed income. This has pushed many investors into doing the wrong thing at the wrong time. I recommend that retirement investors should remain open to an approach emphasizing total returns. If the income stream is not enough, it is OK to sell some stock to meet current income needs -- as long as you have a portfolio that includes growth.

In Part 1 of this series I described the total return concept.

This installment, Part 4, analyzes another of the strategies, covered writes. I urge readers who are new to the series to go back to earlier installments, especially the first two, to catch up.

What is a Covered Write?

A covered write has two parts-- the underlying stock and a "call" option sold by the owner of the stock. Simply stated, a call option gives the buyer the right, but not the obligation, to buy a stock at a specified price for a specified time.

This is most easily understood with a concrete example. Let us take Noble Corporation (NYSE:NE), whose stock closed yesterday's trading at a price of 35.61. The December 37 call was 70 cents bid, offered at 73.

If you own the DEC 37 call, you have the right, but not the obligation, to buy the stock at $37/share at any time through December 17th. If the stock is above $37 on that date, you would exercise the call, claim your stock at a price of $37 and (perhaps) sell it at the higher price to lock in your profit.

If you instead sold the DEC 37 call, you have the obligation to deliver stock to the owner of the call. If you own the stock, and the price is over $37 on expiration day, you will probably be assigned on the call and forced to sell your stock at a price of $37. If you do not already own the stock (a naked short of the call -- not discussed or recommended here) you are now short the stock at a price of $37. You need plenty of spare margin in your account to deal with that!

To summarize, if you own the stock and sell a call you collect the call price, called a premium. The call has a specific date and a strike price, 37 in our example. If the stock is still below 37 at expiration, the call expires worthless and you pocket the premium while still owning your stock.

The chart below (click to enlarge) shows the profit and loss potential for an investor choosing to own NE.
NE Covered Write

I am illustrating this with an investment of about $10,000 or 300 shares. The chart shows the profit potential from selling three DEC 37 calls (each contract is for 100 shares) against this position. When compared with the results from a simple stock position, the calls show an additional gain of $210 (the call premium collected) unless the stock moves above a price of $37. At that point the gains are capped.

By selling the call (referred to as "writing the call" in options lingo) the owner of the stock has pocketed some extra cash, but given up on the gains beyond $37 per share. The extra profit may seem small, but it is over 2% in one month if the stock is flat or higher. Not bad -- and you can do it over and over, each month.

Choosing the Right Position

There are two parts to finding a good covered write position -- the best stock and the best call sale. Many adherents of the covered write approach focus on the maximum return from the call. This is a mistake. A large call premium reflects extreme stock volatility, a synonym for risk. Others may well disagree (and I hope we get plenty of discussion on the article), but I prefer starting these positions by finding a stock with good fundamentals.

The Right Stock

This is not an article about stock picking, but some stocks are particularly suitable for writing calls. It helps to start with a general market viewpoint, but there is some flexibility. I think the market is in a gradual upward grind as the prominent worries are proven to be false. In this environment I especially like stocks that will share in the gradual climb and have limited downside risk (usually from a strong balance sheet or cash flow). I am using Noble Corporation in this article, but there are many other candidates including Microsoft (NASDAQ:MSFT).

In the current market, I do not like stocks that have frequent big gaps and huge volatility, even though these generate large call premiums. An example of a candidate that I own but do not favor for call writing is Apple Computer, Inc. (NASDAQ:AAPL). In AAPL, I do not want to cap my upside. Most people trying to time entries and exits in Apple wind up missing out on big gains.

The Right Call

Once you have chosen a stock, you still must decide which call to sell. To help in this you can look at the option "chain." This shows the alternatives and prices for each available strike and a variety of expiration months. The image below is a screen shot from Born to Sell, a very helpful service that provides many custom views, key metrics, and screens. (Click for a larger image).

NE Call Chain
I have the following December choices:
  • The DEC 35 call with 4.5% downside protection and 2.5% return if the stock is flat;
  • The DEC 36 call with 3.1% downside protection and 3.2% return if the stock is flat:
  • The DEC 37 call with 2% downside protection and only 2% return on the call.
Why did I choose the DEC 37? It provides the potential gain of another point in the stock, which is another 2.8%.

To summarize, your choice of call depends upon your expectations for the stock. If you are more bearish, you want additional downside protection.

Playing the near-term options gives you the greatest time decay. Each month you can write a new call, but it does require active management.

In a flat market, the extra yield is very significant.
Using Technical Analysis
Technical analysis can be helpful in deciding the stock range for the upcoming month. Here is the chart for NE (click to enlarge).
NE Chart

While charts are open to varying interpretations, readers may see why I view this as a good candidate to trade between 35 and 37, with an upside bias.

Risks in Covered Writes

The biggest risk to a covered write position is that the stock declines. This is the same risk that you have for stock ownership, but you get a little protection from the call sale. There are fancier strategies that provide more downside protection, but I am sticking to the basics as part of my analysis of the Quest for Yield.

The investor must also check out commissions for stock trades, options trades, and charges if you are assigned on the call and must give up your stock. Some brokers charge less than one cent/share on each and nothing on assignments. Others have significant fees. This is important to investigate, since fees can quickly eat up most of your extra yield.

Further Reading

This article is intended to provide a good introduction to the most important single strategy for adding yield. It is barely a start on the analysis of covered writes. Mark Wolfinger, a veteran trader and a colleague from my days at the Chicago Board Options Exchange, has a helpful web site for getting started in options trading. His book (now added to our recommended reading list), The Rookie's Guide to Options: The Beginner's Handbook of Trading Equity Options, has three chapters on this subject.

For those who get interested in options trading I also read and recommend Adam Warner and Bill Luby. Both sites will help you understand volatility, the key component in option pricing. Their sites also have links to other valuable resources, including a regular free newsletter.

Conclusion
The effective use of the covered write can dramatically increase yield. As usual, I emphasize finding good stocks as the first step.

The covered write strategy is compatible with a bullish market viewpoint, but it can also provide extra protection for those who are worried about their stock positions. In a flat market, selling calls can still generate double digit gains when nothing else is working.

There is some extra work involved in trading options, but it can be well worth the effort.