Covered Calls · Investing

Option(al) Income

As with anything investment-related, see my disclaimers. This post deserves an additional disclaimer. Investing involves risk. Trading stock options is extremely risky and you can lose 100% of your investment. My story is provided solely for entertainment purposes and in no way do I recommend doing what I did. Or anything else, for that matter.

I was eating lunch with coworkers a few days ago and the topic of stock options came up. I related to them my recent experience writing covered calls against stock that I acquired through a previous employer. They had many questions that I hope to address in this post.

Risky Business

What’s a covered call? A call is simply an option contract the owner to buy a given security at a fixed price by some expiration. A call is “covered” when the seller of the call owns the underlying security while a “naked” call is when the seller doesn’t own the security. Selling a “naked” call has, in theory, unlimited risk because the underlying price of the security could go to infinity and the seller would at some point need to buy the stock to cover their position, possibly at a terrible loss.

A few years ago, a former employer awarded shares of the company as part of the compensation package. Over my tenure at the company, the stock price roller coasted through peaks and dips. It was my policy to immediately sell all shares as soon as I received them. I had enough tied up in the health of the company and would be better served by diversifying my portfolio. However, towards the end of my tenure when the price was relatively low, I held on to a small portion of the shares.

Why did I suspend my policy and keep the shares? I was pretty sure that the stock has hit the bottom of a dip and would recover. And there’s some hope for a buyout.

But hope is not a sound investing strategy. I’ve slowly been divesting myself of the stock over the intervening years through both selling and donating shares. The remaining shares are still worth more than when I received them, but at times I wonder if I would have been better served by selling all of the shares, paying the capital gains taxes, and then investing the remainder in index funds.

I’m not in a hurry to pay the capital gains taxes. A buyout doesn’t seem imminent, despite rumors, but it is a possibility. I’m not quite ready to abandon my position, but I’d also like to do something more than just have the shares sitting around, taking up valuable investment dollars.

Taking Action

Enter my covered call strategy.

Early last April, the stock was trading at $15.81 and the premium for a $16 call contract expiring in June was $1.03. The call straddled the company earnings date. My risk was that the company’s earnings report would be stellar and the price would shoot up, capping my gains at $16.84. On the downside, if the stock dropped then I’d be protected until it breached $14.78.

What happened? The stock bumped a little at earnings, then trended down until it hit $14.36 and I exited the position, a month later. I bought the call that I’d sold at $.14, earning $.89 per contract and getting to keep the shares. Instead of losing $1.45/share, because I’d sold the calls, my net loss was only $.56/share. Selling the covered call had acted as an insurance of sorts, protecting me somewhat from a decline in the share price.

Here’s a chart of the profit comparison of selling a covered call. You can see how selling the call protects the downside some but also limits the upside profit potential.

Because the stock price never reached $16 by the expiration, the calls I had sold would have expired worthless. If I had stayed in instead of buying back my call, I could have pocketed the remaining $.14/share. But I wanted to free up the shares in order to write another covered call.

Lather, Rinse, Repeat

Throughout 2019, I experimented with covered calls, selling them when I felt the price was at the top of the range, and buying them back once they had come down. I never had shares exercised out from under me, but I always sold options at strike prices that I’d be comfortable with selling them so it wouldn’t have been a big deal. During 2019, my shares appreciated 2% and my dabbling added nearly another 2%. I only sold calls against a fraction of my shares–no more than 30% of my total shares at any time–so it could have been higher, at least 5% by my calculations. I never went all in just in case a buyout occurred.

Here are my trades during 2019:

Option Sold Repurchased Delta
6/21 @ $16 4/29 @ $1.03 5/24 @ $0.14 $0.89/share
9/20 @ $16 5/24 @ $0.73 7/31 @ $0.16 $0.57/share
6/21 @ $18 6/13 @ $0.02 Expired $0.02/share
9/20 @ $17 7/3 @ $0.43 7/31 @ $0.19 $0.24/share
9/20 @ $18 7/30 @ $0.41 7/31 @ $0.09 $0.32/share
9/20 @ $16 7/31 @ $0.15 8/2 @ $0.06 $0.09/share
12/20 @ $16 8/2 @ $0.74 10/18 @ $0.51 $0.23/share
3/20/20 @ $18 11/25 @ $1.08 12/31 @ $0.64 $0.44/share

No Free Lunch

My covered call approach is a zero-sum game. So who was on the losing end? There are always those in the market who are looking to make metaphorical home runs, buying calls in the hope that the stock will explode. However, like baseball, not every time at bat leads to a home run and many times they strike out.

Would I do this if I didn’t already own the shares?  Probably not. But since I’ll be happy to either hang on to shares should the stock drop, or part with them if it should rise enough, I might as well gain some income from them as they sit there.

To Infinity and Beyond!

I’ve been repeating the process into 2019. I have sold several March 2020 and June 2020 calls and while I haven’t sold any, my paper returns are currently 30% with only 5.5% of that due to appreciation. I’m kinda hoping some of my lots get exercised, just to give me the excuse to diversify it elsewhere.

Have you had any experience, good or bad, selling covered calls? I’d love to hear about it.

Hasta luego!

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