SELLING COVERED CALLS
This article will discuss an income-producing strategy commonly referred to as “selling covered calls”. I’m going to try (and I’ve been recently told I suck at keeping it simple) and make it as simple as possible so everyone can understand. The entire concept took me some time to wrap my head around as well so don’t worry.
WHY SELL COVERED CALLS?
This strategy is often said to “reduce” the risk of trading options, but in my opinion (for what it’s worth) selling covered calls eliminates the risk of trading options and almost guarantees the transaction will be profitable.
Being the seller increases a traders probability of being successful exponentially over being the buyer so really any transaction as the seller is “less risky”. I also do not use the word guarantee lightly. I believe it makes the entire article sound like an infomercial, but in this particular situation it is the best adjective.
The covered call strategy is extremely popular with investors who already own stock and want to subsidize their dividend or, in a market like we have now, try and reduce their pain if they are currently holding a losing position (basically any oil and gas stock). In plain English: you sell covered calls to make money on shares of stock you already own. Period.
Do not confuse selling covered calls with selling naked calls. This is completely different and is extremely risky (yes, much riskier than buying options). Selling a naked call means a trader sells call options on an underlying stock they do not already own. I won’t even waste time explaining the many, many ways you can lose your entire life savings with this type of transaction. In fact, thankfully, most brokerage firms will not allow the average trader to even perform this trade. This is one of the few times in life that doing something naked is actually bad (I couldn’t resist).
WHAT IS BUYING AN OPTION?
When a trader buys an option they are “buying” rights, but not obligations. This is why you must purchase said rights at the premium price which costs you, the option buyer, money.
WHAT IS SELLING AN OPTION?
When a trader sells an option they are “selling” an obligation and providing a buyer the rights. This is why the seller collects the premium (gets paid) for selling because, in life, you should always get paid to take on obligation (risk). Think of it as a legally binding contract (which it is).
WHAT’S IN A NAME?
I have found that all of this makes a little more sense when you know why they’re called PUT’s and CALL’s. Ever wondered that? If you sell a CALL option – the underlying stock shares may be “called from you” at any time IF the buyer exercises his right. As the seller of a call you have the obligation to sell him your shares at the agreed upon price (strike). If you sell a PUT option – the underlying stock shares may be “put to you” at any time IF the buyer exercises his right. As the seller of a put you have the obligation to buy his shares from him at the agreed upon price (strike). A CALL can be called away and a PUT can be put to the seller. Easy!
STRATEGY IS IMPORTANT
Options are used by day traders and long-term investors alike. They can be used to get rich very quickly, become poor very quickly or to assist an already existing long position. There are endless ways to utilize options to be (and remain) profitable in the market.
I could write all day about covered calls and you, the reader, would just get more and more confused. Therefore, instead of continuing to explain, I’m going to provide some real world scenario’s.
The most important thing to understand about selling instead of buying is that time or more importantly time decay is your friend when you’re the seller and your enemy as the buyer – always.
THE REAL WORLD
Denbury Resources (DNR) [stock_quote symbol=dnr]
This is a great stock to use for this example because it’s cheap, worth owning long-term (years) and I believe it has hit rock bottom. Currently, as you can see above, the stock is trading around $1.28 today. If you read my email alert yesterday, you would know it was trading at $1 just 24 hours ago. That’s a 28% gain on the stock alone before commissions. That’s beside the point – thank you James for making me money this morning – I know, I know you’re welcome.
Today you have several options (no pun intended) if you, like me, purchased 10,000 shares at $1.00:
- Option 1: You can hold those shares until you retire (my plan) which means you could sit right here every day from now on and do nothing at all. You, as the long-term investor, will be provided a dividend each quarter for your loyalty in the amount of .0625 per share as of today. This dividend is not stable and could change at any moment.
- Option 2: You could sell said shares today and before commissions profit a 28% gain. Wow, 28% in 24 hours – again thank you James. This is not a bad choice – making 28% in this market is great and by selling you guarantee keeping that 28% gain. So if you’re an active trader or day trader I would not fault you for this. I might wait until $1.35 though…
- Option 3: Since you (I) now own 10,000 shares of actual stock which we intend on holding long-term we can sell covered calls against those shares with limited risk. This is the preferred option and the option we will discuss further below.
SELLING COVERED CALLS ON DNR – IN DETAIL
- The first step has already been completed. Purchase shares (preferably at least 10,000) of the underlying stock of your choosing. Remember, some companies / stocks provide much better option premiums than others. Alcoa is good for selling covered calls as well because of this fact.
- Determine how much profit or gain you would be willing to accept and therefore be obligated (remember you’re being paid to accept this obligation) to relinquish the shares of stock you purchased. This is important.
- I personally am comfortable with a 100% gain on my 10,000 shares purchased at $1.00 and would be willing to have them called away or lose said shares if I can make 100% gain. I accept that offer. So how do I make it happen? I sell the $2 strike for the expiration I feel comfortable with. If I’m assigned (exercised) I am guaranteed to make $1 per share profit with the $2 strike. You with me?
- As a long-term investor I have no idea what DNR or oil is going to do in 2016. No one does. So it’s hard for me to determine if DNR is going to hit $2 tomorrow or in six (6) months so really with this example I just need to choose a strike I’m comfortable with regardless of what happens. The further out you sell (time) the more money you are paid because the larger the “risk” you are taking. You are being paid more for time – time is money! Is it really a risk when you’re guaranteed to get paid if the underlying hits your chosen strike price? I think not. The only risk you are accepting is whether or not DNR will be at $8 or $10 by the expiration date and you will only make 100% gain instead of 800-1000% gain. With DNR that’s an actual risk, but that’s typically rare with a normal equity.
- I’m comfortable with accepting the above risk that DNR will not be above $2.00 by JUNE of 2016 and I want to SELL 100 contracts of the JUNE 17 2016 2 CALL which is currently trading at .20 cents per contract. I am also comfortable with selling my shares at $2.00 per share (the strike) which I will be obligated to do if exercised.
- By executing this transaction $2,000.00 is immediately deposited into my account. I am paid to provide this right to another buyer. Now we wait.
During the above steps 10,000 shares of actual DNR stock was purchased at $1.00 per share. The total cost of this transaction was $10,000 (plus commissions). By executing this transaction, we are now shareholders in DNR and the 10,000 shares can be held forever or until DNR goes bankrupt at which point the shares are worthless.
If you believe publicly traded companies cannot or do not go bankrupt, I’ll be happy to discuss HERO Offshore and MOLYCORP Mining with you over some serious alcohol.
Since our 10,000 share position in DNR is for the long term, and I do mean long, long term our goal is to make money or profit from owning the stock and not just from the dividend. Therefore, we determined what profit margin we would accept and potentially be forced to sell the shares (the $2 strike or 100% gain) and sold 100 contracts (equivalent to 10,000 shares) of the June 2016 $2 Strike Call option for .20 cents or a $2,000.00 premium. We were paid the $2,000.00 premium to accept the obligation to sell our 10,000 at $2 if the buyer exercises his right anytime between now and the June expiration. At this point, we’re waiting.
It is often said buyers of options make money 35% of the time while sellers of options make money 65% of the time. Why you ask? The market moves up, down and sideways. Sideways is when a stock just sits there hovering for days, weeks or months. Ford is excellent at this. Actually, many stocks are excellent at this: GE, KO, T to name a few. When you buy an option you are anticipating a move in one direction – either up if you bought a CALL or down if you bought a PUT . By selling you are likely to make money in two (2) of the three (3) directions not just one (1) so your odds are much better.
MORE REAL WORLD
You wake up and it’s April. Wow time flies doesn’t it? You have patiently held your 10,000 shares of stock, you were smart and didn’t blow the $2,000.00 premium you were paid. You are sitting pretty with two (2) grand and an underlying stock price of $2.48 for DNR up from $1.92 the night before. You just passed your $2 strike price of the option you sold back in February. What now!? There is a 99.9% chance your option will be exercised and your 10,000 shares will be “called” away. Is this bad? Not really. As the investor who purchased DNR stock at $1 in February, you just made a 100% gain and $10,000 profit on the stock itself plus the $2,000.00 premium! Not bad at all.
However, the underlying is at $2.48 why didn’t you make the extra $4,800.00? Because you chose the $2 strike and that’s what you obligated yourself to sell your shares for. Your assumed risk was the potential for the stock to go higher than $2.00 which it did. Did you lose money? NO! You made $12,000.00, you just didn’t make AS MUCH as you could have. That was the risk. Some risk right? Let’s assume that indeed you’re exercised and your stock is called away. What does that look like for you, the seller, after all is said and done? Let’s break it down:
- The 10,000 shares are called away and you are paid $2.00 per share. After subtracting what you paid ($10,000 for 10,000 shares at $1 per share) for the underlying shares you are left with a $10,000 profit. So there is 10k.
- You were paid $2,000.00 when you sold the option – which you get to keep for taking on the risk. Boom – another 2k.
- IF any dividends were handed out while you owned your shares of stock you get to keep the dividends too. Sweet! For this example, let’s say you were paid the $625 for 10,000 shares at .0625 cents per share. Another $625 gain.
- Total gain IF the stock trades above your predetermined strike price of $2.00 and your shares are called away: $12,625.00 profit on a $10,000 investment. Not a bad way to make a living.
HOW ABOUT SIDEWAYS?
You wake up on JUNE 18th 2016 only to find DNR is STILL trading at $1.28 (sideways) as it has been since February and nothing has changed. Normally, as a long-term investor in DNR you would have purchased the stock in February and been paid the normal dividend of .0625 cents per share for the 2nd quarter (more than likely). You would be up 28% on the stock and received your dividend. However, let’s break this scenario down and see what happened had we sold the covered call as well:
- The underlying stock is trading at $1.28 per share as it did in February and nothing has changed. You’re still up 28% before commissions, but that’s it.
- You received the second quarter dividend of .0625 cents per share totaling $625.00. The typical investor receives the dividend and goes back to his coffee and donuts. You’re up 28% and get a dividend. Still not a bad way to make a living.
- The JUNE $2 strike call option you sold in February expires worthless to the buyer because the stock did nothing. Did it expire worthless to you the seller? Technically, the option expired worthless – they all expire worthless, but not to you. You were paid $2,000.00 back in February. A gain of 2k on top of everything else.
In summary, the stock did nothing, but by selling the covered call you the savvy trader profited 28% on the stock, you gained the dividend as a normal investor would AND you gained the premium from selling the covered call to the buyer who thought DNR was going up. Your total gain: $5,425.00 and guess what? You still own the stock, made more than the typical DNR investor AND you get to sell more covered calls further out like November and do it all over again making additional premiums on the same shares you already own. Don’t you love this? $2,800.00 on the stock gain, $2,000.00, for the June premium, $625.00 for the dividend = $5,425.00.
HOW ABOUT DOWN?
At some point between February and June the market crashes – AGAIN. DNR crashes to .90 cents per share. The world is coming to an end and you’re losing money like everybody else…but maybe not. Remember, you’re the savvy trader, not the average joe.
- You wake up on that same day in April to find DNR is trading at .90 cents per share. You, of course, as the long-term investor buy more shares first and foremost. Since you are below your original cost basis of $1 per share you are not in violation of trading run number one (1) – never violate your cost basis. So you buy, buy, buy.
- The covered call option you sold in February has actually GAINED value. Why? Because the call option itself is cheaper. Remember, you sold the JUNE call option for .20 cents per share when the underlying was at $1.28 per share. If the underlying is now worth .90 cents per share that same JUNE call option will be worth less as well. Probably .15 cents maybe even .10 cents. Therefore, you could simply buy back the 100 options you sold in February at HALF (.10 cents) the price making a profit. The covered call transaction is complete, your shares are safe, you made money and everybody is happy.
- Another ending: DNR stock remains at .90 cents until June when your covered call option expires. The buyer does not exercise, you keep your shares, the premium for selling the option, any dividends AND you can turn around and sell another 100 more covered calls for August or September or November, etc…to help lessen the pain of losing money on the underlying stock. Make sense?
The underlying stock price for DNR went down. You lost money on the stock itself, but you do not care because you’re a long-term investor and you will simply wait it out knowing it will go back up. No real risk if your plan is to remain long. When the underlying went down, the covered call option you sold in February gained value offsetting the pain or loss you incurred by the underlying stock price going down. This can help a lot! You received the dividend for being a loyal investor and you were able to buy more shares lowering your cost basis because you always keep cash on hand for just such an occasion – right?
As you can see the “risk” involved in selling covered calls is not really a risk as those who buy options are used to accepting. The risk is more…virtual in nature. It’s maybe not making as much money or having to hold on to a stock you already own that may not be performing as well as expected. No matter the scenario, by selling covered calls you have the ability to remain profitable when everyone else is bailing. You also get to leverage the bull’s (like me) who always think a stock is going up and who buy call options. You’re the other side of the equation – the smarter side!
SOMETHING TO THINK ABOUT
Nordic American Tanker, a stock I have discussed in other posts, is another great stock to sell covered calls on. Below is a quick transaction outline that is occurring as I type:
- Purchase 10,000 shares of NAT at $10.90 on February 10, 2016. That’s $109,000 total investment.
- Sell 100 covered calls for the APRIL 15 2016 $14 STRIKE CALL on February 12, 2016 at .45 cents per contract totaling $4,500.00. Intentionally waited a day or two to see if the underlying stock price went up in order to get a better premium on the $14 APRIL option.
- If, by April, NAT hits $14 per share and the 10,000 shares are called away the trader (me) will profit $31,000.00 on the stock gain from where I purchased it and the APRIL strike price, I will keep the $4,500.00 premium paid today for selling the option and maybe even a dividend which currently yields 15% annually. I have not reviewed the calendar for dividend dates so the dividend is in question. Without the dividend (let’s make it easy) the trader (me again) would gain $35,500 or 32.3% profit (ROI) – $31,000 plus $4,500. With a single quarter dividend added, you would gain another $4,300.00. Yeah, that’s $1.72 per share annually divided by four (4) quarters. Bringing your total gain to $39,800 or 36.5% profit (ROI).
Nordic American Tanker (NAT) [stock_quote symbol=nat]
UPDATE (MARCH 30, 2016): The above Nordic American Tanker trade, in two weeks, will have performed perfectly. THIS is a prime example as to why I LOVE being the seller.