I’ve had a number of conversations over the years with investors looking to generate income from their portfolios or possibly unwind large positions by selling covered calls.
Covered calls can be a powerful component to a larger investment strategy — but it’s important to understand them first. Read on for a brief primer on the strategy and how to know if it might be right for you.
What are covered calls, and how do they work?
When you own a call option, you have the right to buy shares of a particular security at a pre-determined price, the strike price. By extension, when you sell a call option, you’ve given someone else that right — so you’re agreeing to sell your shares of a security at the stated strike price.
The “covered” part just means that you already own the shares: You wouldn’t need to go out into the market to get them if your option-holder exercises their right to buy.
Here’s an example of how this might look:
Say you own shares of the (fictional) Bradford Pine Wealth Group Corp (fictional ticker: BPWG), which is trading at $30 per share. You decide that you want to write, or sell, a call option that gives the holder the right to buy 1,000 shares from you at $33 per share.
The option is sold through the Options Clearing Corp., the official clearinghouse for these trades. The market price of your BPWG option will usually be a fraction of how much it would cost to buy the 1,000 shares. Option prices vary and depend on how close the strike price is to the current share price, the option’s expiration date and a number of related factors.
After selling your BPWG option, you receive a payment (so-called income), and the option-holder will start monitoring the stock price to see what happens next.
If the option doesn’t go “in the money,” meaning the share price doesn’t rise above the strike price, you’ll keep your income from the sale, and the option itself will expire on the specified date you chose when you purchase the option.
If the stock price rises to $33 or higher, it might make sense for the option-holder to exercise the right to buy the shares. At that point, the Options Clearing Corp. will match the order with an appropriate seller (you or someone else) and initiate the transaction. (There are many other scenarios here however, for the purpose in keeping this simple, I will leave it at that).
Why was I careful to say that it might make sense for the option-holder to buy?
It’s important to keep in mind that option-holders don’t always exercise their rights, even if the share price is above the agreed-upon sales price.
That’s because there are a few other factors involved. In addition to the stock’s share price, the option-holder needs to consider how much they paid for the option and any additional transaction costs they’ll face in buying and reselling the shares.
How can covered calls be used?
Covered call writing is not for everyone. But for certain investors it can make sense.
Generally speaking, there are three main benefits to writing covered calls:
- Immediate income from selling the option.
- The potential to lock in a certain gain when the option is exercised.
- The ability to manage share sales by limiting the quantity sold and specifying the sale price.
For example, say you have a large position in a publicly traded stock that you want to slowly wind down. Writing covered calls can be a good way to divest your position over time at prices you’re comfortable with, while generating some income in the meantime. Some investors find that using covered calls can make the sales process a little more orderly and less emotional than trying to time the market or manage sales decisions in the moment.
Similarly, covered calls can be a good option for those who are seeking income on a larger portfolio of stocks. Selling options provides income and can help you maintain exposure to equity growth potential while offering some downside protection against price volatility. These portfolio-level strategies require a careful balancing act between generating income, keeping growth potential in place, and softening the impact of potential drops in share price.
What are the risks?
If you decide to write covered calls, you must be willing to:
- Sell your shares at the agreed-upon price.
- Accept the possibility that you could lose out on upside potential.
- Maintain exposure to the typical risks involved in equity investing (i.e., a loss of share value).
The key risk to keep in mind is that you’re capping upside potential. If the option-holder exercises their right to buy your shares, it’s usually because the share price rose higher than the agreed-upon price — and you won’t get the benefit of that extra growth.
It’s also important to remember that covered calls do not eliminate the risks involved in owning shares. You’ll still be exposed to the risk that the value of your shares might fall. While the impact of price volatility can be reduced through the income gained by selling shares, it is never completely eliminated.
Finally, keep in mind that there are tax implications to writing covered calls. These transactions can generate significant taxable income, which is why they are often better-suited to tax-advantaged accounts.
Using covered calls wisely
Covered call writing can be powerful. It can help investors unwind large positions in an orderly manner or generate income on a relatively stable and balanced portfolio of equities. In other words, it can offer both practical and financial benefits.
But it’s important to be prudent, careful, and certain that it’s a good strategy for your particular situation.
That’s why I almost always recommend working with an experienced and specialized professional. Options are complicated, even if you’re dealing with a single stock that you’re very familiar with. A professional can help manage the analytics, balance the risk-reward profile, and make pricing decisions that maximize your potential gains while helping to protect you from greater losses.
Written by Bradford Pine with Anna B. Wroblewska
Brad Pine is a wealth adviser and president of Bradford Pine Wealth Group, based in Garden City, N.Y. BP Wealth Group assists individuals and entrepreneurs to create wealth, simplify their lives and plan for retirement. Honesty, integrity and reliability are the foundations of Pine's investment philosophy.
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