Covered calls, an income-producing strategy, are a good option for investors seeking to produce income, while maintaining some flexibility in short / long-term capital gains, while at the same time providing a hedge against stock depreciation. This article is meant as a primer for medium-skill investors seeking a lower-risk option strategy.
As an illustrated example, we'll take a look at Enbridge (ENB, TSE: ENB), Marathon Oil Corp. (NYSE:MRO), and Teva Pharmaceutical (NYSE:TEVA). In my estimation, Enbridge, a Canadian crude delivery company, is a solid player in the energy space. In addition to capital appreciation potential, the stock makes for a great income play. And although, at least for U.S. investors, there's a 15% Canadian dividend withholding tax, any savvy stockholder can build that in to Enbridge's hefty yield, while still expecting solid ROI and dividend appreciation potential - a great option for income investors. What's great about the stock, while running covered calls against the underlying security, is its yield is magnified by writing options against what should be a core long-term holding.
That being said, one of the problems with writing covered calls is stocks can be "called" away, meaning if the underlying security exceeds the strike price, the investor must relinquish the stock - in this case, Enbridge. As to the particulars on Enbridge, let's take a proverbial look "under the hood." For sake of argument, let's assume an investor holds 100 shares, which is the minimum holding to write calls against it; an investor must have at least 100 shares to their name. Currently, the stock is paying approximately $0.43 per share (on its dividend), or $43 on 100 shares, with a record date of 2/15/17. But for the sake of argument, investors need to hold Enbridge by 2/13/17, the stock must settle by COB on 2/13/17 and it's almost impossible for U.S. investors to hold Enbridge in book entry. Instead, you need to own the stock in a brokerage account, so the important date is 2/13/17. Any stockholder who holds Enbridge shares by COB on 2/13 will receive $43 or whatever else is owed based on the number of shares owned.
In addition, when writing a call, investors receive a "premium" - a premium is what's paid for the right to call away shares when it exceeds its "strike price." A good place to check options data is either with your broker or Yahoo Finance. Checking the data, the next option expires on 1/20/17. As a general rule, investors want option expiration to be sooner rather than later. This gives you the best shot to be "right" or "out of the money," meaning the option expires worthless, you still receive the premium and an investor can repeat the process over and over and over again. When I first started writing covered calls, my goal was simple, I wanted to beat the interest paid on a bank account - which, as you might know, is next to nothing. I found that if you were skilled in your call writing, it was somewhat easy to do while managing risk.
The great aspect I like best about writing covered calls is what I call the "stock trifecta." This situation occurs when timing your covered call for a dividend, receiving a premium as well as your shares being exercised. You get the dividend, the premium, as well as capital appreciation. This situation (in my estimation) in particularly attractive when your stock is a long-term holding but you are looking to sell anyway. You're getting money from the dividend, the premium, plus whatever money is received from your capital gains, but your capital gains are limited to the amount up to (strike price - cost basis).
My general rule in writing covered calls is to go into it knowing if that your shares are called away, your profits will be less than they otherwise would be if your shares exceeded the strike price. But it's important not to get too greedy - you probably won't get rich writing covered calls, at least not in the short term, but you'll get one heck of a lot more money than a bank account. And in fact, if you've successfully written several call that expire worthless, an investor can stop, wait for the stock to appreciate, and then the calls you wrote effectively "amplify" your gains.
For sake of illustration, I took a couple of stocks and wrote covered calls against them. Enbridge ended up expiring worthless on one occasion, and it got "called away" the second time I wrote a call, so I received a premium for the first option written, another premium for the second time, a dividend, as well as the amount up to the strike price in short-term capital gains. On another occasion, I decided to write a call on Teva Pharmaceutical. At the time, I was on a trip to London, and the stock sunk like a rock. I still received the dividend and the premium, so my losses were offset to some degree, but I decided to cut my losses on what IBD calls a "falling knife."
As a third example, I decided to invest in Marathon Oil Corp., and this was by far the most lucrative and successful covered call strategy of the three. I wrote calls against my Marathon shares over and over and over again. Some of the calls were short term in duration, and others were more long term. But those premiums added up to big time money, as I received several dividend payments on those shares. The dividends weren't a lot, but they definitely added to my overall gains. By the time my shares ended up getting called away, since I held about 5 contracts (a contract is 100 shares), the amount of money made was a tidy sum. Marathon was somewhat of a "risky" / high beta holding, but that risk paid off.
Taking a look at Marathon at today's price, which is currently $17.45, it's a little too high (in my estimation and on a historical basis) to make any money from. It's true there is potential, but my gut tells me there's a greater chance to lose money than to gain, so I'm staying put for now and waiting for a correction (and we're long overdue for a correction).
So in a nutshell, that's the 411 on writing covered calls. It's a great strategy if you're just starting out with options and want to stick your toe in on a risk-managed basis. Give it a try, you might be very pleased with the results. Premium, dividend, and upside potential and protection against stock depreciation is a winning combination, at least in this market. Have fun!
Disclosure: I am/we are long TEVA.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.