Options strategies began growing in popularity after the establishment of the Chicago Board Options Exchange (CBOE) in 1973 when investors sought creative ways to enhance their returns and manage their risks using options.
Covered calls are one of the popular options strategies used by investors worldwide. This involves owning the underlying shares of a security and simultaneously selling a call option on those shares. The seller of the call option receives a premium from the option buyer, resulting in immediate income for the seller.
Unlike dividends from stocks, the premium received when selling a call option is not subject to taxation in Singapore. This premium can be used to purchase shares or options right after the call option is sold. This advantage is one of the many reasons why the covered call strategy is widely employed and popular among experienced investors.
Understanding covered calls
To shed light on how covered calls work, here is an example: John bought 100 Tesla shares (US: TSLA) at US$200 ($274) per share. He then decides to sell a call option at US$10 with a strike price of US$220 with an expiration date of one month from now. This means that John will receive a total premium of US$1,000 (US$10 x 100 shares) for selling the call option.
Referencing Chart 1 below, the following two scenarios could play out for John after adopting a covered call strategy: Scenario 1:
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Stock price below strike price (US$220)
Firstly, if the stock price is below the strike price, the call option will likely expire worthless for the buyer. In this case, the seller, John, will keep the premium collected (US$1000) from selling the option and retain ownership of the shares. John will also have the option to roll forward the contract by opening another covered call (known as the “wheel strategy). This flexibility is another reason why covered calls are popular, as investors can continuously generate income by selling call options while holding onto the shares they wish to keep.
Scenario 2: Stock price above strike price (US$220)
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Alternatively, if the stock price rises above the strike price, the call option buyer may choose to exercise the option and buy the shares at the strike price from John. In this case, John is obligated to sell the shares at the strike price but keeps the premium collected. This would amount to US$220 per share + US$1,000 premium from the covered call. It’s important to note here that the potential downside of using a covered call strategy is the limit of John’s profit potential should the stock price continue to rise beyond US$220.
Benefits of covered calls
As mentioned earlier, covered calls offer a way for investors to generate income while retaining possession of the underlying shares during a stagnant market. They have the potential to increase yields, especially for stocks that do not typically pay dividends. In a way, covered calls can be seen as “creating your own dividend”.
Furthermore, if the strike price aligns with the investor’s take profit level, the premium from the covered call enables the seller to take extra profit in addition to the shares getting called at the strike price. The income generated can subsequently reduce the investors’ breakeven cost on the underlying shares.
A covered call strategy is also adaptable to various market conditions depending on the investment goals and current market conditions. In a bullish market, a covered call strategy can be used to set profit-taking targets for investors and to collect additional premiums. In a neutral to bearish market, investors can still generate income by selling the call options while retaining the shares.
However, the main reason why investors sell covered calls is to actually take advantage of the decay in time premium. Time premium is the portion of an option’s premium that is associated with the time remaining until the option’s expiry and it diminishes as time passes. To take advantage of this time premium when selling contracts, it is important to note that there is a period for exponential time decay typically within a period of 30 days to 45 days.
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From Chart 2, it is evident that there is an accelerated rate of time decay as the expiration date nears. By understanding this graph, it allows a call option seller to thoroughly evaluate the risk of holding the option through periods of uncertain market conditions. This assessment aids the seller in deciding the optimal selling price and managing the possibility of an assignment for the option.
Additionally, the relatively straightforward nature of covered calls makes them accessible and friendly to most investors including newcomers. Lastly, their value shines particularly in markets that lack directional movement, given their potential to amplify returns even when the market is consolidating.
Potential drawbacks and risks
While covered calls come with their advantages, they have a notable drawback often referred to as “limited upside” or “opportunity cost loss.” This happens when the seller has the obligation of selling the shares, thereby having the shares “called away” at the agreed-upon strike price to the buyer, foregoing potential upside should the share prices continue to rise. Nevertheless, investors still have the option to repurchase the shares if their price drops, and the strike price can then act as a profit-taking level instead.
In summary, covered calls remain a popular trading strategy within options, providing investors with the means to realise profits in the prevailing market environment. They are generally considered a conservative strategy suitable for investors who are looking to generate additional income from their stock holdings while mitigating some downside risk.
However, like any trading strategy, it should be implemented with careful consideration of individual goals, risk tolerance, and market conditions. When used effectively, covered calls can be a valuable addition to an options trader’s arsenal, contributing to a well-rounded and potentially profitable investment strategy.
Thng Xiao Xiong is a senior dealer, UK equities, at Phillip Securities
