"I was recently introduced to the concept of the covered call strategy, and it seems to make a lot of sense. However, after researching the strategy more in-depth, it appears that it doesn't generally work well. Why is this? And what can I do to earn income on my current holdings?"
Covered call payoff chart
The covered call option strategy is one that certainly doesn’t get the respect it deserves. It essentially works like this: you agree to sell your stock in XYZ company to another party within a specified period of time at a specified price (“strike price”). In return, you receive a premium from the buyer of this option. Sounds like a pretty simple concept, right? So first, let’s review the benefits of writing covered call options:
1. You earn money on your holdings even when the stock price is flat over a period of time
2. The value of your holdings (underlying stock and call option together) will be much less volatile: when the price of the stock drops, the value of the call option also drops – meaning you can buy the call option back at a lower price, should you choose
3. For value-oriented investors, the covered call strategy forces you to sell when the price gets above a certain threshold, generally minimizing future losses
4. You can sustain a certain level of losses on the underlying stock and still break even due to the premium paid to you for the option
So if this is such a great concept, why doesn’t everyone use it?
The covered call strategy has been ill-employed in the past, causing poor performance, followed by a general disinterest in selling covered calls. This is most likely because, in the past, the strategy was to sell options with a strike price x% higher than the current market value of the stock. Unfortunately, this strategy does not take into account the volatility of the stock. For example, selling a monthly call option for Coca-Cola (low volatility stock) that is 5% higher than the market price will most likely net next to nothing since the chances of Coca-Cola growing 5% in one month are extremely low. Conversely, selling a monthly call option 5% higher than the market price for high volatility stocks such as Tesla or Questcor Pharmaceuticals isn’t unreasonable.
So what is the best way to take implied volatility into account when selling call options? Instead of setting the strike price as a percentage of the market price, choose a percentage return you would like to receive on your option sales (say 1% for monthly options). Then find the call option with a “bid” price closest to this number. For example, if XYZ stock is trading at $100 and you want to earn 1% on this monthly option sale, choose the strike that has a “bid” value of $1 ($100x1%=$1).
Once you decide what strike price you would like to sell against your holdings, take a look at the MACD and Bollinger Band charts of the underlying stock. The best time to sell a call option is when the price is approaching the upper band of the Bollinger Band and the MACD line is decreasing (momentum slowing, possible reversal coming). This will allow you to get paid the highest premium for your stock holding, with the greatest possibility that it will drop in value in the near future (remember: drop in option value = gain for you).
1. You earn money on your holdings even when the stock price is flat over a period of time
2. The value of your holdings (underlying stock and call option together) will be much less volatile: when the price of the stock drops, the value of the call option also drops – meaning you can buy the call option back at a lower price, should you choose
3. For value-oriented investors, the covered call strategy forces you to sell when the price gets above a certain threshold, generally minimizing future losses
4. You can sustain a certain level of losses on the underlying stock and still break even due to the premium paid to you for the option
So if this is such a great concept, why doesn’t everyone use it?
The covered call strategy has been ill-employed in the past, causing poor performance, followed by a general disinterest in selling covered calls. This is most likely because, in the past, the strategy was to sell options with a strike price x% higher than the current market value of the stock. Unfortunately, this strategy does not take into account the volatility of the stock. For example, selling a monthly call option for Coca-Cola (low volatility stock) that is 5% higher than the market price will most likely net next to nothing since the chances of Coca-Cola growing 5% in one month are extremely low. Conversely, selling a monthly call option 5% higher than the market price for high volatility stocks such as Tesla or Questcor Pharmaceuticals isn’t unreasonable.
So what is the best way to take implied volatility into account when selling call options? Instead of setting the strike price as a percentage of the market price, choose a percentage return you would like to receive on your option sales (say 1% for monthly options). Then find the call option with a “bid” price closest to this number. For example, if XYZ stock is trading at $100 and you want to earn 1% on this monthly option sale, choose the strike that has a “bid” value of $1 ($100x1%=$1).
Once you decide what strike price you would like to sell against your holdings, take a look at the MACD and Bollinger Band charts of the underlying stock. The best time to sell a call option is when the price is approaching the upper band of the Bollinger Band and the MACD line is decreasing (momentum slowing, possible reversal coming). This will allow you to get paid the highest premium for your stock holding, with the greatest possibility that it will drop in value in the near future (remember: drop in option value = gain for you).
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