When most investors think of using options to hedge against declines in the market, they think of buying puts. And that is certainly a valid strategy. But we see benefits in using options in another way, a way that allows for investors who are bullish in the long run to hedge against short-term declines in the market, as well as lower the cost basis of their investments.
Covered calls are one of the more conservative options strategies, in which an investor writes (sells) calls against equities or ETF's that they already own. The impact of this is twofold.
Maximum potential downside is limited: Because you collect premium for selling the call (and that premium is yours to keep), your maximum potential downside is lowered. When you are long a stock or ETF, your maximum downside is simply the amount you invested. And when you sell a covered call against that position, your cost basis is lowered, thus lowering your maximum losses.
Upside potential is capped: Writing the call means that if the stock reaches the strike price, it will almost certainly be called away from you. That is why it is crucial to sell a call that is far enough away from where the security is currently trading at for it to provide enough upside.
Click to enlarge:
Click to enlarge
Because of the rationale behind this trade, it does not really matter if the rally is sustainable in the short-term. This trade is structured for investors who are bullish in the long-run, but wish to hedge their short-term exposure.
This trade works with both general markets and specific equities. We will illustrate it with the general markets, as represented by the SPDR S&P 500 ETF. We will be illustrating this with one contract, however it can work in any increments of 100 shares (as a reminder, options contracts require blocks of 100 shares).
As of this writing, the SPDR is trading at $140.44. Let us assume that we bought 100 shares of it when it was trading at $120, for a cost of $12,000. We have an unrealized profit on this investment, but are worried about where it's going. We may be bullish in the long run on the S&P 500, but are worried about a short-term decline. As tempting as it may be to simply sell our holdings, we are worried that the market may simply continue to rally when we sell, thus costing us upside. In addition, if this is a taxable account, we would be incurring capital gains taxes in a situation where selling is not exactly essential.
Therefore, rather than selling, we decide to write an upside call against our holdings. For instance, we could sell the April 21 $143 call (this is an example used for illustrative purposes), collecting a premium of $94 dollars. At first glance, that may seem like a pittance compared to the $12,00 we spent to acquire our position. However, it is important to remember what the call means to us. If the SPDR fails to trade up to $143, then the option will expire worthless, and that $94 is ours to keep. And should the market continue to rally, and the SPDR reaches $143, we not only keep the $93 worth of premium, but all the unrealized profits on our investment. It is the first outcome that represents the hedging aspect of this trade. Should the SPDR fail to reach $143, or fall, this $94 premium would serve to lower our losses, and if we wish to, allow us to invest in additional shares with "the house's money."
The key factors in determining which call option to use is the premium received and how much further upside in the underlying security you can catch. If you think the market SPDR could rally past $143, it makes no sense to use that call, as your profits are capped at $143. Every investors personal preference level determines how far out the strike price will be. Furthermore, investors can continue to sell upside calls as each one expires, thus maintaining a rolling covered call position and collecting a steady amount of income from the premiums. If the underlying stock never reaches the strike price, then you have the premium income. And if it does reach the strike price, then you will have realized a good profit on your investment (assuming you picked a strike price that matched your investment goals).
Picking the right strike price becomes even more essential when utilizing this strategy with individual stocks. If you own shares of a stock you think will rally sharply in the future, it makes no sense to write a call below that level, since your upside will be capped. Therefore, when using covered calls with individual stocks, it is important to use them with a stock that will not surge through the strike price unexpectedly. It does you no good when the biotechnology stock you own gets acquired by a large pharmaceutical company at a 100% premium, and your upside is capped at 5% because the strike price on the call options you sold are 5% above where it is trading now. Therefore, stocks that you are bullish on, but expect to be relatively stable until options expiration are the ideal types of stocks for this strategy. Such stocks allow you to collect premium income and still receive a good profit if it were to hit the strike price.
While covered calls may not be the most obvious type of hedge against a short-term decline in the market, we think they can be useful to investors who are bullish in the long-term, but want to lower their potential losses in the short-term, and generate some income in the process. As long as investors choose a strike price at which they are comfortable having their profits capped, we see covered calls as a good way to reduce losses and provide income, as well as provide for reasonable profits if the option is exercised.
Disclosure: I am long DIA.