Mention the term covered call investing strategy, and many investors picture limited upside potential, with the potential for making a small profit. These investors may also consider the real beneficiaries of the covered call investing strategy to be the sellers of the call options who benefit handsomely when the price of the stock increases significantly.
A covered call is a stock options strategy wherein an investor sells a call option against an existing stock or against a stock purchased specifically for the covered call investing position. A covered call is similar to purchasing a house and leasing it out with an option to purchase. The person leasing-out the house receives a monthly income, however the person leasing-out the house may lose his income-generating vehicle if the person leasing the house decides to exercise the option for purchasing the house.
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A profit and loss graph for a covered call looks like this:
Just like a landlord leasing out his property, a covered call investing position can generate monthly income by re-writing or selling call options against a stock. For this strategy to work, the call option needs to expire worthless at options expiration.
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A real-world example will be considered in order to illustrate the concept of re-writing a covered call position.
On 4/27/2009, PowerOptionsApplied‘s Titanium newsletter published a covered call position for American Express (AXP). At the time, the price of AXP’s stock was at $24.89 and the price of the sold call option (AXPEE) was $1.70. The call option had an expiration for May of 2009 with a strike price of $25. Not applying any type of management, the maximum potential return for the AXP covered call was 7.8%. The maximum potential return of 7.8% is partially a result of time premium ($1.70) and appreciation in the price of the AXP stock price ($0.11).
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At options expiration on 5/15/2009, the price of AXP closed at $24.23, so the May 2009 call option expired worthless since $24.23 is less than the strike price of $25 for the call option. The initial premium of $1.70 for selling the call option was retained as profit. The price of AXP was less than at entry by $0.66, so the total profit generated by the covered call investing strategy was $1.70-$0.66 or $1.04 which represents a return of $4.5%, not bad for only 19 days in the investment.
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On 5/18/2009, a new call option (AXPFE) with expiration in June of 2009 and a strike price of $25 was sold against the existing AXP stock for $2.10.
At options expiration on 6/19/2009, the price of AXP closed at $24.64 and the June 2009 call option expired worthless, as $24.64 is less than the $25 strike price of the option.
On 6/22/2009, a new call option (AXPGA) with expiration in July of 2009 and a strike price of $24 was re-written against the AXP stock for $1.15. The price of AXP was down on 6/22/2009 at a price of $23.23 which is why the call option with a $24 strike was sold rather than a call option with a $25 strike as used previously. The call option with the $24 strike was selected as it had the most potential return with respect to time-value, the other call options for AXP had significantly less potential return.
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At options expiration on 7/17/2009 the price of AXP closed at $28.03 and since the stock price was greater than the $24 strike price of the call option, the call option was exercised and the AXP stock was called away.
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The total return generated by selling the call options against AXP was 17.8% and the total return from simply purchasing AXP and holding it would have been 12.6%.
| Return Selling Covered Calls Against AXP | Return with Buy-and-Hold for AXP |
| 17.8% | 12.6% |
By using the covered call investing strategy, the return generated for AXP was increased significantly over a buy-and-hold strategy.
Additionally, instead of allowing the AXP stock to be called away on 7/17/2009, an investor could optionally have rolled the July 2009 call option to an August call option and prevented AXP from being called away. For example on 7/15/2009 when AXP was at a price of $27.22, the July call option could have been purchased for $3.20 and rolled to an August call option with a strike price of $27 for $2.00. This new position would have had the potential to add an additional 7% of return to the AXP investment.
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PowerOptions’ sister company PowerOptionsApplied provides expert stock option trading recommendations. PowerOptionsApplied specializes in covered calls, naked puts and iron condor stock options strategy recommendations. PowerOptionsApplied provides a 30-day risk free trial of its service.
[tags] leasing, re-writing, AXP, American Express Co. [/tags]