May 4, 2021
By: William “Bill” Speth, Chief Research Officer
“Buy low, sell high” is a well-known, if not over-simplified, mantra for successful investing. In my personal experience, however, deciding to buy a stock is often much easier than deciding to sell, and letting go of a stock that has been held for a long time or carries an emotional attachment can be especially difficult.
The most successful traders I know come from a variety of backgrounds and use a variety of techniques. Yet, all tend to share a common trait: they are highly disciplined in their approaches to investing. When they enter into a trade, they typically pre-plan an exit strategy that can include setting target prices for taking profits.
Options can be used to help establish that investment discipline. By selling covered call options, investors effectively get paid for agreeing to sell their stock at pre-determined, higher prices.
Take, for example, an investor who inherited shares of a company that have appreciated in value and now represents a large portion of her net worth. The investor is comfortable owning the stock but is increasingly uncomfortable with the risk of holding a concentrated position. She knows that selling some shares is the prudent thing to do but is also bullish on the stock and doesn’t want to sell at the current market price.
A covered call strategy can help this investor develop a disciplined approach to selling stock above the current market price – and the opportunity to earn additional income along the way. Assuming a stock price of $100, the investor could hypothetically sell call options on a portion of the stock position with a strike price ranging from $110 to $115, and with 2 months until expiration, for about $1 per share or roughly 1% of the stock price.
If the stock price on the expiration date is above the call option strike price, the investor would be obligated to sell shares 10% – 15% above the current market price – in line with her strategic objective. The “effective sales price” of the stock would be the option strike price plus the money collected from the call sale. If the stock does not reach the pre-defined target, the investor would simply keep the proceeds of the option sale.
With a disciplined program of selling covered calls, the investor could achieve her goal of diversifying a concentrated stock position while earning additional income on what would have otherwise been an idle asset.
For the many investors who don’t own large blocks of stock, selling covered calls can be an effective strategy for opportunistic short-term trades. For example, imagine that you bought hypothetical company XYZ for $40 per share, following a very sharp 60% decline from a 52-week high. You like the stock, but analyst ratings are mixed and you recognize that it may take some time before the stock price fully recovers.
Typically, when a stock drops rapidly, option prices tend to increase due to an increase in expected volatility. In this example then, assume you could sell an XYZ call option with a strike price of 50 that expires in 6 weeks for about $0.80 per share, roughly 2% of the stock price. Putting this in perspective, assume that the hypothetical quarterly XYZ dividend is only $0.24 per share, an indicated annual yield of about 2.4%.
As in the concentrated stock example, if XYZ shares are above $50 when the call expires, you would sell your stock above the market and realize a 27% gain based on an effective sale price of $50.80 (strike price plus option sale price). If XYZ is below $50, you would keep your shares, keep the proceeds of the option sale, and could repeat the process by selling another call option.
While the covered call strategy is one of the building blocks of the options market, it is important to understand the risks that are inherent in selling upside calls on stocks. When a stock price surges higher – and such moves can occur because of earnings reports, analyst ratings changes, economic news, and other factors – the covered call strategy can prove challenging to even the most disciplined investors.
For that reason, it is important that anyone considering a call selling strategy to be mindful of the potential for upside regret. Still, disciplined investors, with a disciplined strategy for buying and selling stocks, may find that selling covered calls can help improve the performance of their equity investments.