Covered Calls

What are covered calls?

Covered calls is a low-risk, low-return, highly scalable options strategy which allows you to generate regular income stream from your stock holdings. However, there is no free lunch and it comes with a few caveats:

1) You must have 100 shares minimum of the stock you are selling covered calls on.

2) You are limiting your profit potential from the stock you write calls on for a certain period of time. (This is not as bad as it sounds as I will explain later.)

When do covered call work best?

Covered calls work best with specific type of stocks and unfortunately, people typically pick wrong stocks to write covered calls on. In general, covered calls work best

- in choppy markets (2022 is a great year for covered calls, in my opinion)

- stocks that have range bound behavior

- 20-40% implied volatility stocks

- stocks that pay dividends.

- stock that have a confirmed golden cross

- stocks that the investor have slightly bullish bias (no more or less than "slightly")

- stocks that you have very high conviction on and do not mind holding irrespective of short-term price swings. 

The biggest favor that a covered call investor can do to him/herself is to begin with the right stock at first place. Unfortunately, from what I have observed, this single most important step is typically where people make biggest mistakes.

Tesla vs Walmart: Which one is a better CC candidate?

A volatile momentum stock like TSLA is not the best covered call candidate.

You are probably better of just buying and holding if you have a bullish view on TSLA. For a momentum stock like this, it is not worth collecting modest covered call premiums and giving up gains from the appreciation of stock price. 

 

WMT, on the other hand, is a solid covered call candidate because it has been range-bound for quite some time, pays a nice dividend and have low volatility. This would enable the investor to collect covered call premiums while receiving dividends and also gains in stock price. The last thing you want your covered call stock to do is major moves.

  

TSLA can be a much better stock or company than WMT but that does not make it a better stock for the covered call strategy !!

 Mechanics of a Covered Call

Let's take a look at the options chain to see how this strategy works.

Below is the options chain of WMT on Interactive Brokers platform. 

By the this screenshot was taken WMT had a price of $138.82.

We are currently looking at Feb25 options chain (which is 7 days out from the date of the screenshot).

If you look at the call side, you can see bid and ask prices which are basically the premiums you would collect after selling your covered call. For any given strike price, that is the income you would get. For instance, if you write the $140 call you would collect $130 (by ask price) weekly income. If you write $143, you would collect $46, etc. 

If the stock finishes Feb25 below the strike price you have chosen to sell your calls (say $143), you would keep the full premium ($46) and re-do the strategy for next week or month. 

If the stock finishes the week above the strike price, then you also keep $46 premium but have to sell your stocks at that strike price ($143).

If your shares are called, you can sell a put to get assigned further shares and re-start the whole process which is called the "wheel" strategy. However, you can miss out on dividends and capital gains if the stock makes a big move, because your max gain is capped at strike price + premium collected. You can earn any more than that ($143.46 per share, in this case) in this week.

That is why, this strategy works best with channel-bound stocks like WMT. Stocks like this demonstrate choppy behavior with low volatility so that you can keep collecting your premiums without getting assigned or the stock losing much value. Over the long-term, your covered call premiums and dividends should pile up and reduce your effective cost basis on the stock substantially. 

 What can go wrong? 

It is critical to know the worst possible outcome before starting any investment. With covered calls, the worst case scenario is if the market dips too hard. In case of WMT, this could mean, for instance, the share price dropping all the way to $110-120 level. This would not impact the dividend payouts (which is way it is important to pick companies with a good dividend track record. WMT has increased its dividends for past 48 years) but the covered call gains will likely drop because the investor would be selling far OTM (out of money) calls with lower deltas. 

 

If, say, your average price is $139 and WMT drops to $120, then you would likely be selling calls with strikes around $135-140 (rough guess). You can technically go lower to collect higher premiums but then your shares might get called with a spike in stock price and you might end up closing the whole trade at a loss, wiping out all the prior premiums that you have patiently collected.

 

As presented in my Walmart challenge video #1 on my Youtube Channel, the below is a scenario modelling of my covered call play. The worst case captures the above-mentioned circumstance with low premiums, still yielding a 9% return, in line with annualized average S&P 500 returns. The base case a return of 15% which is more than most funds and indices make on an average annualized basis. The ideal scenario for the covered call strategy would be the stock to trade in a channel without making sudden spikes. This way the investor would be able to generate rental income via covered calls while also benefitting from the appreciation of the stock price. However, if the stock goes up too much, then the shares would get called, limiting potential future upside.

 

The right mindset

The best analogy for the covered call strategy is owning a real estate and renting it out. Yout 100 Walmart shares would be your property. The covered call premiums are your rental income along with the dividends you collect. Ask yourself: if you owned a real estate, would you get its price re-calculated by an expert on a daily basis or would you have a long-term approach and just care for your tenant's rent payments in short-term? Very likely the latter, right? Because the underlying assumption you had when you bought your real estate is that its value would go up over long-term anyways and therefore short-term price movements are not relevant. Therefore, I prefer to calculate my return on investment without considering the daily market price of the stock. As displayed in the above table, this would mean calculating the return as (total premiums collected) / (deployed capital), the latter being 100 times your stock price average.

The Wheel

A good way to start the covered call strategy is to sell a put at a slightly higher than usual strike price to collect some nice premiums up-front and get assigned the shares. Alternatively, if you think the stock is at a good value point already and sitting a support level, you can do a "buy-write" by simply purchasing 100 shares and selling your calls. In case the shares get called after selling a call, the ideal next strategy would be to sell a put again to be able to get assigned shares back.