The Covered Call / Buy-Write Strategy
For better or worse, most investors purchase stocks with the
intent of holding their shares for an extended period of time.
We do this mainly because the media and industry professionals
have drilled into our heads, year after year, time after time,
that it’s best to buy and hold. The recent bull market
phenomenon also fueled this mindset because the ‘buy and hold’
strategy worked extremely well - for a while.
Whether or the not the ‘buy and hold’ strategy is still the most
efficient way of investing remains a topic for discussion.
However, it is still the strategy that most investors are
comfortable with and tend to follow.
The first strategy we will discuss is a hybrid of the buy and
hold strategy, one that provides for better and more consistent
returns a large majority of the time when compared to naked
stock ownership alone.
When we buy a stock, there are three possible outcomes. As we
discussed previously, two of these scenarios are generally
negative and only one outcome is generally positive. If the
stock goes up, that is good. If the stock goes down, that is
bad. And if the stock stays still, that is also a bad outcome.
To briefly recap, not only do you have a loss in opportunity
cost (the money invested in your stagnant stock could be making
you money if somewhere else) but also, you have incurred
commission costs on both the way in and way out. So, in this
case, only one of the three scenarios provides a positive
return.
For the sake of description, we will identify the three
potential scenarios as the “up” scenario, the “down” scenario
and the “stagnant” scenario. By employing the covered call or
“buy-write” strategy, you can change the outcome of the scenario
profile so you have two positive potential results instead of
only one.
Employing the covered call or “buy-write,” we still have the
“up” scenario as a positive result, but now the “stagnant”
scenario will also produce a positive result since we collect a
premium and the third scenario, the “down” scenario will not be
as negative.
Thanks to the covered call strategy, now two of three scenarios
end in a positive result and the third has a result that is less
negative.
Let’s take a closer look at the covered call strategy and its
construction. There are two components of the covered call
strategy, the stock component and the option component.
The stock component consists of a long stock position (you own
stock). The option component consists of selling one call per
every one-hundred shares of stock owned.
Remember, one option contract is worth one hundred shares of
stock. So for example, 1000 shares of stock equals 10 call
contracts or 200 shares equals 2 call contracts.
The chart below shows more examples of the proper construction
of buy-writes.
Please take special note that the ratio of stock to calls must
be exactly 100 shares to 1 option contract.
Number of Shares Owned Call Contracts to Sell 100 1 300 3 1700 17 9200 92 14500 145 267000 2670
The philosophy behind the covered call strategy is not
complicated. It entails using a long stock position along with a
short call option to create a positive stream of additional
income, much in the same way a person would purchase a house and
then lease it out to collect rent in order to pay for the
mortgage.
Another analogy is that of the insurance company. An insurance
company receives premiums month in and month out. Over a period
of time, this constant stream of income easily builds to a point
where it outweighs any pay out the insurance company may face,
even for catastrophic events.
The constant and reoccurring collection of option premiums works
better if done over longer periods of time (for example, one
year.) That time frame allows the odds to play into your favor.
Now let’s talk about the odds. There have been several studies
done on the topic of premium buying versus premium selling. The
goal of the studies was to determine whether it is better to buy
options or sell options.
Recent studies have found that selling the premium was the
correct trade 78% to 83% of the time. That is a very high
percentage and is worth taking advantage of when a good
opportunity presents itself.
The covered call strategy takes advantage of the fact that an
option is a depreciating asset because its extrinsic value goes
to zero at expiration. The process by which an option’s
extrinsic value dissipates is called time decay.
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