Disclaimer: None of the following is legal or financial advice in anyway, and respective advice should be sought from an appropriate professional.
Recently I wrote about whether options contracts were confusing or not and it can easily be argued that I perhaps didn’t exactly put many minds at ease … especially when I went as far as to say that there are strategies that can be used for any sort of market situation, or that there were up to 20 various strategies that can be used with certain variations … before I suggested that you realistically only to know about 3-5.
I understand that there could be some people out there who might have suffered some mental whiplash.
But what if there was just one strategy that did it all? What if there was only one strategy that you actually needed to know?
For some of you out there … there might just be.
Welcome to Covered Calls.
The Concept
So, what is a Covered Call?
‘A covered call is constructed by holding a long position in a stock and then selling (writing) call options on that same asset, representing the same size as the underlying long position.’ [1]
Think of it like this. Imaging buying an Asset outright and then selling an option for a pre-determined value to sell the stock at an agreed upon price, that only takes effect if the price of the asset rises above the agreed upon price, by the expiration date.
What happens if the price doesn’t reach that agreed upon price? If the value of the asset does not reach the agreed strike price, then the contract expires worthless and the owner of the stock … the asset (you) get to sell another contract and collect even more income.
If you look at the process, this is a strategy that offers a fixed and limited upside potential, but provides fixed income upfront, which offers significantly more than any bank or dividend. Although this is primarily an income strategy, over the long term, it also provides significant growth opportunity.
Related: Are Options Contracts Confusing?
The Entry – Cash Protected Put
So, the covered Call strategy offers the means to generate 2-4% (typical) passive income for about 10-15 minutes’ worth of work per contract. Not bad right? So how do you set one of these up?
There’s the ‘normal’ way, where the trade can be setup via buying the stock and simultaneously selling (writing) the call option, also called a ‘Buy-Write’ which opens the trade and collects the income upfront. If a stock is trending upward, you can set the trade up for that trend.
But what happens if the price action is or has been flat for some time? What if there was a way to generate income before you take ownership of the stock?
This is where we get to look at the ‘Cash Protected Put’
In contrast to owning the stock and then collecting income against it, the Cash Protected Put, demands that the trader has the equity to take stock at an agreed price and whilst generating income before potentially taking the stock if the price falls below the agreed strike price.
Why does this even matter?
This allows the trader, to start earning income against a stock without actually owning it, but still being willing to do so. It also allows the trader to ask for a lower price than the current value, resulting in an even lower effective entry.
Related: Dividends. Are they Worth it?
The Covered Call – A Profitable Exit.
Regardless of how you end up with the underlying stock, buying it upfront or getting it via assigned Put options, the covered call is not just a way to generate passive income.
It is also fundamentally a way to exit the trade profitably, whereby the sold Call, collects an income and potentially sells the stock for a pre-defined profit should the market rise, leading to potential additional gains.
This is where complete commitment comes into play, and exposes the trader to what can be thought of as the biggest enemy in the market … themselves.
The moment a covered call is entered into, the trade is ‘effectively’ locked in. The call has been sold, income has been generated. The strike price is set and any potential capital gain is ‘locked’ in.
Whatever happens from here, requires the discipline to let the trade play out. If the price action moves upward, it means committing to the yield and gain that you already committed too. If the price moves down, it means, letting the market do its thing and coming back up later.
But what if the market looks to be going down and keep on going?
Related: ETF’s, Stocks & Options, Which is better for your money?
Is there a Downside? Management.
For an income strategy that also offers potential capital gains, for so little time investment there has to be the question, is there a downside?
Well … Yes, Kinda, Sort of. At least two keys downsides that need to be addressed before diving in.
Firstly, cash protected puts and covered calls can tie up your money/equity, and also put you into a position where you might not be able to act on other opportunities when they come up. Trading strategies that make use of stock, are far more restrictive than other types of options trades.
In short, they’re capital intensive, and as long as you have a position in play, you can potentially carry a trade for weeks or even months, until it closes. Ultimately, allocation plays a big part. Go too heavy in stock strategies and smaller, shorter term trades may need to be passed up. the same works in reverse.
Secondly there is the whole concept of unrealized losses, particularly when the value of the underlying stock drops. This is really where your headspace comes into account. Its also a matter of matching a longer-term trade with a stock and company that you’re willing to hold for the longer term. Good quality companies, with strong fundamentals will fluctuate with price, but there is also the reality that prices can and do move downward. Even good quality stocks have suffered. Just take a look at TSLA, NVDA, before coming back up as two examples.
Corrections and Pullbacks aren’t something to worry about in the long term. But that isn’t to say, downside protection should be ignored. Just take a look at Silicon Valley Bank, (SIVB).
Even stock strategies such as Cash Protected Puts and Covered Calls, can be protected to a point. You can protect with a strategy known as a Collar, which acts in a similar way to a stop loss, but without the instantaneous act of closing the trade. Collars that are open to the downside, can really help you sleep at night knowing what the worst-case scenario is in advance … e.g. … SIVB
What happens if there is a drop?
There’s a few different ways to manage the trade at this point, you can keep it going, or let things follow through, reset and start again. And here we haven’t even dealt with the whole issue of the stock price recovering, where a lot of trades end up going wrong. Covered Calls that end up in the red can be managed in some different ways, and should a trade end up deep in the red, then the same precautions should be considered to cover the rebound to the upside.
Although there are two key considerations to be aware of, the one thing about owning stock is the following. Time is on your side and you can take as much as you like.
Related: 4 Ways to Protect your trades?
What makes them so Useful?
“By the time one gets to learn about how to setup for each of these situations, there is nearly (I said nearly) no need to ever need to get your hands-on full fat stock.”
Are Options Contracts confusing
When trading ‘Pure’ option strategies, generating income is easy. Getting to Keep it is something else. And even when you get to keep it, there is the question about whether it’s useful. Making 30% on a $1,000 trade is outstanding, but … not exactly life changing. That money is potentially better to stay in the account and offset the next trade or get compounded.
When we look at a covered call or a cash protected put, because the option itself is covered or protected by stock or equity, the profit collected from the premium, is locked in … and that means the moment the option is sold, you can actually pull the money out … unlike needing to wait for the trade to close.
So, in essence, the short option can be simply left alone to its fate, while all the income from the premium is put to work elsewhere. When the amount of equity being deployed is large enough this can become income replacement.
To put that into context, if the premium of a stock yields 4% for a monthly trade, then one trade can do what a bank does yearly in about 1-2 months. If you allow for compounding and long-term growth, those percentages only get even more powerful.
I have mentioned that there are other strategies, and some are far more lucrative, but it does require personal investment, and this is the time and energy to learn all about them and when to use them.
Depending on your appetite for knowledge and appetite for management, there is every reason not to even think about all the other possibilities out there. Covered Calls … Cash Protected Puts … are they the best strategy? Honestly, that is up to you … but you’d be pretty hard pressed to find something that offers more for so little time and stress.