Selling aggressive covered call options (i.e. aligning the strike price at or near the current price) to generate current income may augment overall portfolio returns while mitigating risk. In brief, options are a form of derivative trading that traders can utilize in order to initiate a short or long position via the sale or purchase of contacts. In the event of a covered call, this is accomplished by leveraging the shares one currently owns by selling a call contact against those shares for a premium. An option is a contract that gives the buyer of the contract the right, but not the obligation, to buy or sell an underlying security at a specified price on or before a specified date. The seller has the obligation to buy or sell the underlying security if the buyer exercises the option. An option that gives the owner the right to buy the security at a specific price is referred to as a call (bullish); an option that gives the right of the owner to sell the security at a specific price is referred to as a put (bearish). I will provide an overview of how an aggressive covered call is utilized and executed to generate current income and mitigate risk. Further details focusing on actual examples of selling in-the-money covered calls and the ability to sell these types of options in an aggressive manner to generate cash in one’s portfolio will follow.
A Few Characteristics To Keep In Mind For Covered Call Options Trading
1. Strike price: Price at which you can buy the stock (buyer of the call option) or the price at which you must sell your stock (seller of a call option).
2. Expiration date: Date on which the option expires.
3. Premium: Price one pays when he/she buys an option and the price one receives when he/she sells an option.
4. Time premium: The further out the contact expires the greater the premium one will have to pay in order to secure a given strike price. The greater the volatility, the greater the time premium.
5. Intrinsic value: The value of the underlying security on the open market, if the price moves above the strike price prior to expiration, the option will increase in lock-step.
Aggressive Covered Call Characteristics
The main objective of selling aggressive covered call options is to generate income however one must be cognizant of the underlying security of interest. This underlying security must provide certain characteristics in order to optimize premium income:
1) Adequate volatility – the greater the volatility the underlying security undergoes, the greater the premium value.
2) Adequate liquidity – the underlying security must be traded in high volumes and open interest within the option contracts must be high as well in order to execute trades on a frequent basis.
3) Premium yields – taken together, these two characteristics dictate premium yield and typically for a security that meets these criteria can often reach yields of 3%-5% for bi-weekly or monthly contacts.
As the main objective rests in generating current income, relinquishing shares is a likely possibility as these are trades not necessarily investments. Despite not being an investment per se, one should target securities where in the event the option isn’t exercised he is content with remaining in the position.
The Aggressive Covered Call Example
If a stock trades at $100 per share on the open market and one purchases shares of the underlying security at $100 he can turn around and sell a covered call at or near the current price for a high premium. In this scenario, one buys the call option at a $100-$101 strike price and he has the right to purchase the stock for $100 regardless of the stock price between purchase and expiration. If the stock rises to $150, he still has the right to buy the stock for $100 prior to expiration. Since the payoff of purchased call options increases as the stock price rises, buying call options is considered bullish as notated in the introduction. In this case, the buyer believes the stock will increase in the near-term and buys the right to purchase the stock below where the buyer believes the stock price will be in the near term. When the price of the underlying stock surpasses the strike price, the option is said to be "in the money" and at this point, the buyer may exercise the option contract. Conversely, if the stock falls to below $100, the buyer will not exercise the option, since he would have to pay $100 per share when he can buy the stock on the open market for less. If this occurs, the option expires worthless and the option seller keeps the premium in the form of cash as profit. Since the payoff for sold call options increases as the stock price falls, selling call options is considered bearish as indicated in the introduction. The seller believes the stock will trade sideways or move to the downside over the near term and thus is willing to leverage his shares while collecting premiums. A comprehensive overview is depicted in figure 1, illustrating the example discussed above (Figure 1).
Figure 1 – Fictional sequence of events and overview of an aggressive covered call option and its possible outcomes in generating current income
Option Expires Worthless
As outlined above in figure 1 three fates of the covered call can come into in play. Remaining consistent with the example of stock X, the owner of stock X sells a covered call at a strike price of $100 to maximize his premium payout. Per my hypothetical example above, the owner initiated his/her position at $100 and thus has not captured any unrealized gains as the stock currently trades at $100. If the share price fluctuates but remains below $100 throughout the contact timespan, the option will not be exercised. In this case, the buyer of the call would be able to buy the shares on the open market for a lower price than the $100 and thus relinquishes the $3.00 premium. This scenario will result in the option seller keeping the shares of company X and keeping the premium. Effectively this will decrease the option seller’s share price by $3.00 or put another way will provide the option seller with a 3.0% yield from its current price in cash. These option contracts are typically weekly, biweekly and monthly. This $3.00 premium is typical for a near or in-the-money covered bi-weekly or a monthly call contact. On a monthly basis, this translates into a conservative 36% return in cash assuming the shares are not called away.
Option Is Exercised
Since the owner is selling the option at a strike price of $100 this potentially adds an additional 3% from its current price if the option is called. Factoring in the premium of $3.00 per share this brings the total option return of 3.0% (solely obtained from $3.00 for the premium). From the original purchase price of $100 and the current price of $100 the option seller has an opportunity to realize a 3% gain via the option if the shares are called ($3.00 premium). If the shares of company X appreciate above the strike price, then the option seller misses out on any appreciation beyond the $100 per share and the shares will be called away.
Buy To Close The Option
If the stock of company X decreases during the contact timespan not only will the intrinsic value of the option decrease but the time value will also evaporate. The further away the stock price is from the strike price the lower the option value. If the option decreases from $3.00 to $0.25, the option seller can buy to close the contact for $0.25 and capture the spread of $2.75 while canceling any right the buyer had to purchase his/her shares. Now these shares are back to the owner as well as the $2.75 spread in net cash.
Conclusion
The aggressive covered call option is a way to utilize options to mitigate risk, generate income via premiums and augment portfolio returns. The basic framework and keys to selling covered calls is outlined above. The next piece will focus on more specific examples and criteria regarding selling aggressive covered calls and optimizing stock leverage. This is a powerful way to generate income, accentuate portfolio returns if the stock of interest decreases in value, trades sideways or trends upward (without crossing the strike price threshold) as the premium will be kept despite any of these outcomes. To offset the risk of losing out on potential appreciation, the option seller is paid a cash premium that is deposited into the option seller’s account and never relinquished. Taken together, the owner of an underlying security can leverage his/her shares in a meaningful manner to mitigate risk and generate income to augment portfolio returns. This can be performed in an aggressive manner as long as the options are sold at or near the current price (in-the-money). This exercise can be repeated on a monthly basis for healthy yields that can be very impactful to any portfolio over the long-term.
Thanks for reading,
The INO.com Team
Disclosure: The author has no business relationship with any companies mentioned in this article. The author has no business relationship with any companies mentioned in this article. This article is not intended to be a recommendation to buy or sell any stock or ETF mentioned.
