Options are an incredibly useful tool for investors to understand. They can be essential for risk management & hedging investments, or simply to engage in speculation for maximizing returns. However, they are also an interesting way to make passive income if you position yourself as a seller of options instead of as a buyer. Every time that you purchase an option there is a premium that you pay for the right to that option, and if you are the one selling the option, you would collect the premium. For our purposes, we will only be discussing selling call options because of the specific strategy that we’re looking at.
Basics of a Call Option
The exchange that both parties agree to in a call option is as follows:
As a purchaser, you receive the right, but not the obligation to purchase 100 shares at a set price at a certain time
This provides leverage, since if the price of the shares is far above the strike price at expiry, then you get to realize the share price gain, with the comparatively smaller amount in options
In contrast however, if your stock ends up below the strike price, you would lose 100% of your investment
In our new position as the seller, we are selling that same right to purchase a stock at a certain price at a certain date, and collecting a premium to do so
This provides us a risk-adjusted return, where we calculate the guaranteed return of the premium as bigger than the risk associated with the stock going up too much theoretically.
Where Covered Calls come in
Interestingly, there is a way to virtually erase the risk of physically losing money on a stock you own, while collecting money through options trading - this is called covered calls. If you are reading this now, it is almost certain that you own some stocks of your own with the goal of long-term share price appreciation. Now, should you not own any stocks long at this time, the strategy will be pretty ineffective, and a lot more risky, though it is still interesting to understand.
The crux of a covered call strategy is that if you already own a stock and think it will go up regardless of the options, you can sell short-term call options on that stock, collecting the premium, while also being fully insulated if the stock goes up a ton. Let me illustrate this with a stock, say Qualcomm (QCOM):
The current price of the stock is $166 and the premium for an option ending feb 4 (a week from now), is $6.55 at a strike price of $167.5
Now let’s evaluate the potential movements in price and your benefit/cost in each way should you sell the call option:
If the stock goes up a ton, you get the stock price appreciation to your strike price (around 1%) and the $6.55 in premium. That means that the stock would have to go above $174/share in a week for you to make less money than by owning the shares. At the same time, you get a guaranteed return of 4% from the premium + the potential 1% if the stock goes up. Essentially, you are insulated from any loss because you can only lose potential earnings, and even that loss is reduced by the premium.
If it goes down a ton, your losses are reduced because of the premium received, and since you would have owned the stock anyways, that would have been a loss you took whether you traded the option or not, but the hit was lessened by your call option sale.
If it trades flat and stays below the strike price, you got the premium, and kept the stock - best case scenario.
If it trades flat and goes slightly above the strike price, you lost your shares but made money overall through the premium, and you can buy back the shares if they are still cheap and repeat the cycle.
The strategy essentially removes the risk from the risk-reward equation with options. The only ways you can lose is opportunity cost (which is not a real loss, but a theoretical one), or the underlying asset depreciating - depreciation that would have occurred anyways if you were holding the stock.
Variability in Strategy
Of course, as with any financial instrument, there can be a lot of variability in your strategy.
If you never want to realistically be forced to sell the shares and want to simply collect some extra premium, you can set very high strike prices and collect very small premiums on short-term options. If you want to maximize premium, and don’t mind buying, selling and rebuying the same shares, you might be more aggressive with in-the-money call selling - which has the highest premium. Option prices are also variable through factors like implied volatility. Of course, the more volatile a stock, the more potential it has to pass your strike price, and so the more valuable the option is, which means more premium. As such, you might prefer to focus on selling calls on your more volatile tech plays to maximize your collection of premium. Of course, again, this can go the other way, and you can pick low volatility shares that provide a smaller but more consistent payout. The final primary variability in the price of an option comes in its timing or Theta. The more time given for the share price to rise, the more expensive the option. If you want more upfront cash, then you can sell for longer time horizons. Of course, though that might require less active trading, there is less ROI.
Calculating Return
Let’s go through an example using the same Qualcomm shares:
Assuming that I never have to sell the shares and sell exclusively 1 week till expiry slightly out of the money options, getting a similar return throughout the year as my previous example, I would get a 200% yearly return (4% * 52 weeks). Of course, that is not realistic. If the stock rises past my expectations, the option trade is not profitable. Also, keep in mind that this current period in the stock market has very high implied volatility, which is pushing up the value of premiums and distorting the much lower average payout. Also, if the underlying equity goes down too much, then the premium you collect will be proportionately lower to the value of the shares you bought. In general, the profit expected is much lower than 200%, and carries the risk of losing money on the shares - but if you would own shares anyways, it can be a profitable and loss-limiting endeavour.
Tip
In my experience, it can be quite easy to get caught up in the exciting premiums that abound during earnings season. As a consequence of the wild swings (called IV crush when IV drops off after earnings) that earnings reports can produce, options become much more expensive in response to the implied volatility. This can be incredibly attractive to someone selling calls, but it can also result in substantial unrealized gains. Of course, they can be very profitable if there’s no volatile reaction, but at the same time, if a stock you owned shot up 20% you would be pretty sad to have missed it! All in all, it really depends on your risk tolerance and how likely a stock is to be sensitive to earnings…
Decision
All in all, covered calls can be a very useful strategy that you can use to maximize your profit by owning shares and getting paid while your shares are moving sideways. Unfortunately, the strategy only really works in a risk-reduced way when you are going to be holding certain shares no matter the premium you collect, simply because you believe in the company. This requirement is what takes away the downside, since it would have been realized anyways. There are a lot of ways to vary the strategy to fit your risk profile and individual needs. Make sure to pick your companies well, and not to get discouraged if one of your stocks shoot up and you lose potential gain - it’s a numbers game over a long period of time. Always remember that you are now the casino and not the gambler - you need to focus on risk-adjusted returns over long periods of time.
By: Mateo Gjinali
Comments