I know that talking about investment yields and returns can be confusing, and actually understanding what happens can be even more daunting. However, we are trying to make money on our money, and understanding potential returns—both as percentages and dollars—helps separate good opportunities from those that are less attractive. If you have dabbled with stock options, you understand that the number of possible trades is enormous.
Trading using a covered call strategy is a great way to get started with options. In fact, if you are more of a long-term investor vs. a short-term trader this will likely be the only strategy you need to learn. With covered calls, you sell options to collect premiums, acting as the bank or bookie for those traders gambling on the direction of stock prices. As you likely know from casinos, the house always wins. I like operating as the house.
Covered calls get their name because call options are sold against shares owned in your brokerage account. That way, if the buyer exercises the option, you have the shares to deliver and don’t have to buy what are typically more expensive shares. With a covered call, when you sell the calls, your obligation with the sold calls are “covered” by the shares you own.
You do not need to own shares to start selling calls. Your brokerage account lets you enter buy/write trades where you buy shares and sell calls in the same “multi-leg” trade. Trust me; your broker makes setting up and submitting a buy/write trade easy-peasy.
So what is the math behind covered call returns? Here is a hypothetical example that shows the different return permutations.
Our made-up stock, symbol ABC, trades for $20.00 per share. From the ABC options chain, you have selected a call option that expires in 60 days, with a $21.00 strike price. The option is priced at $0.40.
Options trade based on round lots of 100 shares. So to sell the ABC $21.00 call, you would receive $40.00 for every 100 shares owned. Some quick math shows that $40 is 2% of $2,000 (or, if you’d prefer to think of it this way, $0.40 is 2% of $20.00). That 2% is your cash flow yield for selling calls against ABC shares at $20.00.
The buy/write trade gives us a slightly better cash return. With a buy/write, the trade is priced at a net debit of the stock price minus the option price. So you would enter the trade at $19.60 per share to buy 100 shares of ABC and sell the $21.00 strike price call. Your committed capital for a round lot is $1,960.00. The cash flow of $40.00 remains the same, so your cash yield becomes $40.00 divided by $1.960 equals 2.04%.
You may have noted that I do not include commissions in the calculations. We are now in a world where most brokers do not charge commissions for stock or options trades. There is usually a small fee for each option contract. For example, Schwab charges $0.65 per option contract.
The $40 from selling the calls is yours to keep. If ABC is less than the $21.00 strike price when the options expire, you retain the shares and can then sell more calls backed by those shares. You have locked in the 2% cash return, earned in 60 days.
If ABC is above $21.00 at expiration, the calls will automatically be exercised. Your shares will get “called” away and replaced with $21.00 per share in cash to your brokerage account. In this case, you have earned the $0.40 per share option premium plus a $1.00 per share capital gain. $1.40 is a 7% return on the initial $20.00 share price in just 60 days. I hope you see that making covered call trades multiple times each year can lead to handsome total returns over the course of a year.
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