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A Primer On Covered Calls

Summary

When you own individual stocks or ETFs, you can sell call options against your holdings to create a source of added income.

Investors love the added income to hedge against the performance of the holding's underlying performance, and

Investors also love the added income to reinvest and boost portfolio performance, and

Investors also love the added income to add to their personal cash flow.

A covered call strategy is used to boost portfolio returns while reducing portfolio risk. Sound to good to be true? It isn't - this strategy has been around for a very long time.

The primary motive for the covered call strategy is to earn premium income, which has the effect of boosting overall returns on the stock or portfolio, while providing a measure of downside protection.

As a stock owner, you are entitled to several rights. While one of these rights is to sell your stock while the markets are open for the market price, you can actually sell this right to someone else in exchange for cash paid today.

So simply put, you (the option seller) gives the option buyer the right to buy your shares from you at a predetermined price (strike price) at any time before the options expiration date. These options are called "Call" options.

For instance, if I own 200 shares of eBay (EBAY), I can sell the right to buy my shares from me at a predetermined price (set by the options market), and make money while I do it. Today it trades at $34.23, and if I gave someone the right to buy it away from me at $35.00 over the new three months, I'd make $1.75/share. Each option contract represents 100 shares.

This is how we spell this trade out.

Sell 2 ebay $35 Call @ $1.75

This does a few things for the stock owner.

  1. You get $350 of cash premium in your portfolio now. You can leave it in cash, invest it, or take it as cash flow. 
  2. This creates a hedge to the downside risk of owning eBay. Since that premium is yours now, then ebay could sink by the premium received to give you a break-even point of $34.23 - $1.75 = $32.48.

Also, you'll notice we sold a call option that expires three months from now. Though the options market sets the expiration dates, there are many, many options for choosing an expiration date. Since this example has an expiration date three months from now, it is reasonable to believe we may be able to recreate this strategy four times each year. It is important to note that options prices are set due to supply and demand, as well as implied volatility of the stock. But if we could do this four times per year, then I will receive $7 of premium.

This $7 of premium will provide me downside protection with a 20% hedge as well as $1,400 of annual premium on the $6,846 ebay position outlined above.

Because of the strategies attributes to hedge a stock, while adding income to a portfolio, it is generally considered a conservative investment strategy. 

With my preferences in portfolio management to hit as many singles and doubles as possible, while leaving the big hits and home runs to others, and the risk that goes along with swinging that hard, I love maintaining a covered call portfolio focused on income every month.

Members of the Pearly Pig investment community get ideas and updates each week as well as access to the Pearly Pig Covered Call Portfolio performance spreadsheet with monthly updates.

Annual Performance Goal: The Pearly Pig Covered Call Portfolio

Performance of the Portfolio's Stocks 8.0% - 10.0%
Income Received from Selling Covered Calls (1.5% - 2.0%/month) 18.0% - 24.0%
Dividend Income 0.5% - 1.0%

We are allowing the Pearly Pig Covered Call portfolio to experience average returns with the total returns (capital appreciation and dividend income) compared to the S&P 500 - or 8.5% - 11.0%. I would love to beat the S&P 500 year in and year out, but this is an extremely difficult task and most investors have a hard time beating it occasionally, let along consistently or most of the time.

So with a covered call strategy, we stack the odds in our favor to not only beat the S&P 500 year in and year out, but to crush it. 

As with any type of investment strategy, there are risks to this strategy. But to be sure, there are less risks with this strategy than just building a traditional portfolio of stocks and ETFs. First, as long as you have a call against a stock holding, you need to continue to own the stock holding. For instance in the example above, if ebay were to drop more than the hedge, or break even price of $32.48, then your position will be worth less than what it is was worth when you sold the call option against it.

And second, you could lose out on above-average stock performance if underlying stock shares grow beyond the option's strike price. Again, in the example above, you'll lose out on any gain ebay shares may have if they move beyond $34.23 + $1.75 = $35.98 before the options expiration date.

But to be sure, if you let the shares get called away from you, then you'll receive $35/share and keep the $1.75, for a total return of $7.36% - not too bad in 3 months. 

Why haven't you heard about this strategy from your advisor? In the manner that financial advisory offices are set up, given their technology, time and compliance constraints, and with the other critical activities that advisors must perform day in and day out, this strategy is too difficult to manage. I know - I was a successful advisor for twelve years.

It is simply too hard for an advisor to implement this type of significant activity across his or her book of business (client base). Advisors don't have the time to manage this activity. And they don't have the technology to support efficient management of this strategy either. 

If an advisor can't do it for you, then why should you believe you can do it yourself? This is where your membership in the Pearly Pig investment community comes in. As owner of your money, and master of your own destiny, it is your responsibility and opportunity to understand your goals and future obligations, and how to get there.

There are amazing brand-name brokerage platforms out there to support your work to manage this strategy. I can help you find one that will provide the technology and ease to manage it - and give you free cash to open accounts.

I'm betting once you have a good idea of where you want and need to go, that you'll love the predictability and sweet income generated by a covered call portfolio. 

Questions? Feel free to shoot me a message. I'd love to see all investors understand how this type of strategy can boost returns while reducing risk. 

Want to know more about covered calls? Here are a few of my favorites.

Investopedia

The Options Industry Council

Ready to join the Pearly Pig investment community? We are working to double our money as many times as possible, in the time we have to do it. And we're using the Pearly Pig Covered Call portfolio to do it.

-Ryan

Disclosure: I am/we are long EBAY.

Additional disclosure: Investors are always reminded that before making any investment, you should do your own proper due diligence on any name directly or indirectly mentioned in this article. Investors should also consider seeking advice from an investment and/or tax professional before making any investment decisions. Any material in this article should be considered general information, and not relied on as a formal investment recommendation.