Defensive Investing: Keeping Your Options Open with Covered Calls

[Editor's Note: In this latest installment of Money Morning's "Defensive Investing" series, options expert Larry D. Spears shows investors how the use of a "covered-call" options strategy can provide both protection and profits during volatile and uncertain markets.]

Once you get beyond buying puts or calls for purely speculative purposes, no other options strategy is more popular than employing the use of covered calls - and with good reason: Few investment techniques offer more potential benefits with such a low level of risk.

Defensive Investing
Considered the most conservative of all option plays, this strategy - which basically involves selling (or "writing") one call option for each 100 shares of a stock you own - can be employed for one or more of five distinct purposes:

  1. To generate a stream of additional income - over and above dividend payments - from individual stocks in your equity portfolio.
  2. To generate a stream of income from stocks you own that pay no dividends.
  3. To reduce the effective cost basis of longer-term stock holdings by bringing in option premiums, thus recovering some of the original purchase price.
  4. To provide a limited hedge against potential losses in portfolio value as a result of overall market pullbacks or cyclical downturns in the prices of specific stocks.
  5. As an income-producing substitute for a "limit-sell order" - intended to liquidate a stock position when a specific profit target is achieved.

That's a fairly impressive list of potential benefits for a strategy that essentially costs nothing more than a modest commission - i.e., the position carries no additional margin requirement because the stock you hold "covers" the call option you sell. Plus, the play really has just two potential risks:

  1. You lose money if the price of the underlying stock falls - but less than you would have lost holding only the stock, since the loss is reduced by the amount of option premium received.
  2. The price of the underlying shares rises above the strike price of the call and you are forced to sell your stock at a profit (or buy the call back just before expiration, when it has little remaining time value).

If you're not entirely familiar with options and their terminology, a couple of examples should help clarify what's involved in structuring a covered-call position and demonstrate how it works. (For simplicity and ease of calculation, we'll use a 100-share lot of stock and a single call option in our examples, both of which are based on actual prices from Wednesday, July 7).

Assume you own 100 shares of Bristol-Myers Squibb Co. (NYSE: BMY), which you bought late last year at $22 a share. You've been happy with the quarterly dividend payout of 32 cents a share ($1.28 annually), which represents a yield of 5.8% on your original purchase price, as well as with the performance of the stock price, which now stands at $25.80. However, you'd like a little more income from your investment, and you're also worried the stock price might pull back a bit since it's not far from resistance near its 52-week high of $27.07.

Selling your shares would protect against a price pullback, but you'd lose your dividend income stream. Buying a protective put option would also hedge your position, but a three-month at-the-money put would cost more than BMY's annual dividend brings in - hardly a bargain. So, what can you do?

The answer is, write a covered call option against your stock - a call that's currently out of the money, meaning it has a strike price higher than the present price of your Bristol-Myers shares.

With BMY at $25.80, that would mean selling either the $26.00 call or the $27.00 call, focusing on the options that expire in September (given the relatively low volatility of BMY stock, the July and August calls have too little time value remaining to make the sale worthwhile). A check of the BMY option tables shows that those two calls are priced at $1.02 ($102 for a full contract) and $0.64 ($64). So, since you think BMY has little upside potential at this point and want the most protection against a pullback, you sell the September 26 call for $102.

The immediate impact of this action is that you add $102 (less a small commission) to the income stream you receive from the BMY dividend, lifting your total for the year to $230 ($102 + 128 = $230) and increasing your annual yield to 10.45%.

Or, looked at another way, you reduce your effective cost basis on the 100 shares of BMY from $22.00 to $20.98. Or, looked at still another way, you protect yourself against a pullback in the BMY stock price from the current $25.80 to $24.78.

Finally, should you be wrong and BMY rally to a level above $26.00 on the expiration date (the third Friday of September), you've locked in an additional profit of $1.22 - the 20-cent rise to the $26.00 strike price, plus the $1.02 you received for selling the call - the equivalent of an increase in the stock price to $27.02.

The table below, which shows the possible outcomes for this position at various BMY stock prices on Sept. 17, 2010, should clarify the hedging and profit potential of the covered call sale. The profit and loss numbers reflect changes from BMY's July 7 price of $25.80:

Covered Calls
If Bristol-Myers stock remains below $26.00 a share on Sept. 17, 2010 - meaning the call option expires worthless and you get to keep your shares - you can then turn around and sell the appropriate out-of-the-money December call, adding still more to your income stream. And, you can continue doing so at least four times a year - until BMY finally rises above the strike price of the option you sell and your shares are "called away."

(Note: If you are forced to sell your shares, you can offset the lost income stream by using the money you receive for them as security for the sale of out-of-the-money put options, the premiums on which will make up for the BMY dividends you no longer receive. This strategy - known as selling cash-secured puts - is discussed in a past Money Morning article.)

As noted earlier, selling covered calls can also be used to generate an income stream from stocks that don't pay a dividend - a strategy that can produce a fairly high yield on lower-priced issues. An example might be computer giant Dell Inc. (Nasdaq: DELL).

On Wednesday, July 7, DELL shares closed at $12.45, up from $11.90 the previous day. (Note: From a timing perspective, the best time to write calls is late in the market session on a day when both the major indexes and the specific stock are sharply higher - especially if that move has carried the stock to an area of technical resistance, such as a prior cyclical or 52-week high.)

A check of the Dell option tables showed that the nearest out-of-the-money call, the August $13.00 call, was priced at 60 cents, or $60 for the full 100-share contract, and the November 13 call was quoted at $1.16, or $116. (Note: Dell options are on a February-May-August-November expiration cycle, so a September call wasn't yet offered.)

You opt for the August call (knowing you can sell the November in a little over a month if you still hold the stock), bringing in $60 - which amounts to a yield of 4.81% on the current share price. Plus, you get downside protection to a stock price of $11.85 ($12.45 - $0.60) - or, if Dell rises, an additional profit up to $13 a share, plus the 60-cent premium.

Covered call writing is really a fairly simple process, but it can add significantly to the overall cash flow from your portfolio - and it carries less downside risk than holding stocks alone. The only major risk factor is that you'll miss out on some of the profits if the underlying stock moves sharply higher, putting the call in the money and forcing you to sell your shares at the option strike price (or buy back the call just prior to expiration).

For that reason, most investors view covered call writing as a strategy best suited for flat or mildly bearish market conditions. However, if you pair it with an alternating program of selling cash-secured puts whenever one of your stocks is called away, it can be a steady - and highly profitable - technique in virtually any market environment.

[Editor's Note: Article author Larry D. Spears is an options expert. A veteran journalist and longtime chronicler of the global financial markets, Spears has also written several books on financial topics - including the options-strategy primer: "Commodity Options: Spectacular Profits With Limited Risk." In his most-recent contribution to Money Morning's "Defensive Investing" series, Spears illustrated how options "insurance" could protect investors against short-term pullbacks.]

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