When you write covered calls, you produce greater profits by writing six two-month covered calls per year, than you will realize writing one 12-month covered call per year. Time decay for further-out options is quite slow, so writing options more than few months away is equal to lost time. Based solely on option profits, focusing on short-term ATM or OTM contracts produces annualized double-digit returns.
An example of the covered call and how to identify profit, loss and breakeven points: You purchased 100 shares of stock two months ago and paid $54 per share. Today those shares are worth $58 and you decide to sell a covered call with a strike of 60 and expiration in two months. You receive a premium of 3 ($300).
In this example, you have several crucial price points. Your basis in stock was $54, but because you received 3 for selling the call, you net basis is reduced to $51 per share. This is your breakeven point and if the stock price moves below this level, you will have a loss. With a strike of 60, your potential profits are limited as well. If the underlying stock moves above 60 and the call is exercised, your profits are limited to:
Capital gain on stock:
Exercise price, 100 shares $6,000
Less: Purchase price - 5,400
Capital gain $600
Profit on the covered call 300
Maximum profit if exercised $900
If the call is not exercised, you keep the $300 as profit. And when the call expires or when you close it, you are then free to create another covered call with a later expiration date.
The covered call is not risk-free, but profits can be quite attractive. A $900 on an investment of $5,400 is 16.7% before annualizing. For example, if the time until option expiration is 3 months, annualize this by dividing the return by the time and then multiplying by a full year:
16.7 / 3 months x 12 months = 66.8%
The shorter the term until expiration, the higher the annualized return. In addition, because short-term time value moves quickly, the market risk is reduced for shorter-term covered calls.
Comments