Using Covered Calls to Generate Income and Hedge Concentrated Stock Positions
Occasionally a client comes to me with a “problem” many of us would gladly endure: what to do with their embedded gains in a large stock or ETF position.
Although the gains are often viewed primarily as a tax problem, of equal importance is the holding’s disproportionate impact on the rest of the client’s portfolio. Allowing significant gains to accumulate rather than rebalancing can lead to significant over-exposure to a given stock or asset class, relative to a client’s risk tolerance. I view this as allowing the tax-tail to wag the investment dog, and frequently advise selling, paying taxes and diversifying into a risk-appropriate proper allocation. But there are other options, particularly if the client wishes to use their existing holding to generate additional income.
Deciding to sell a stock you’ve inherited or held on to for 25 years or more can be difficult and even emotional, and as volatility creeps back into the market, increasingly I’ve been recommending alternatives to an outright sale. Enter covered calls (and protective puts, though these will be covered in another post). These strategies are moderately conservative by nature, and both require the investor to already own the underlying securities on which the options are written (sold).
As you’ll see from the example, if you’re willing to sell your stock and would like to generate some income while waiting for your price this can be a good strategy. You should accept that the price of the underlying stock may decrease, however, and as a result you may lose more money than if you had sold the security outright before implementing this strategy. Of course, if your crystal ball wasn’t cracked and you knew the stock would decrease in value there are better options strategies to use.
Options Basics
Options are derivatives of the underlying security, and 1 option contract represents 100 shares of the stock. Although there are complex options strategies, the basics of options are pretty straightforward as there are only two types of contracts, puts and calls. The primary decisions are whether you buy or sell, and if the contract is a put or call! Buyers/purchasers/owners (all the same thing) are considered “long” an options contract and have the right or option to buy (for calls) or sell (for puts) at a specified and predetermined price, referred to as the strike price.
Conversely, those who sell an options contract are considered “writers” of the contract and have an obligation to buy (calls) or sell (puts) at a specified and predetermined strike price. The terms “covered” and “protective” as used above simply mean the holder also holds the underlying stock.
Covered Calls
A covered call strategy can be used when you’re looking to sell an existing holding and are neutral to bullish on the underlying security. It involves selling a call option(s) at or above the current market price of the underlying security, therein committing to sell the stock at that price. In return for your commitment to sell at a predetermined price, you collect a premium (money) when you open the trade. The longer the duration i.e., are you making a 1 month or 1 year commitment, the higher the premium you’ll receive as you are accepting more risk.
Remember you already hold the shares you’re committing to sell. If you did not hold the shares (an uncovered position) there would be considerable risk that you would need to purchase the shares in the market, then sell them for the predetermined (strike) price- a potentially big problem if the shares are selling significantly higher than your committed price.
Here’s an example:
You hold 1,000 shares of XYZ stock given to you by your grandparents 20 years ago. You decide you’re willing to sell if the stock, currently trading for $30, reaches $33. You decide you could use some income in your portfolio and that the risk of the stock selling off significantly is low. You look at the call options and see that you could sell a $33 contract (strike price-your commitment) that expires in 6 months for $2.50. As you hold 1,000 shares, you could sell 10 contracts and all would be “covered”. For this commitment to sell your 1,000 shares at $33, you’ll receive $2,500 upon sale of the contracts (i.e, to open the trade).
Example when stock goes down:
January comes and AMD is now selling for $25/share. No rational person is going to force you to sell your shares at $33 to them if they can go to the market and buy them for $25, so your contracts expire worthless. You’ve kept your $2500 premium which offsets some of your stock losses experienced falling from $30 to $25. You decide to do it again, with a strike of $27 now. Rinse, lather, repeat.
Example when stock goes up:
January comes and AMD is selling at $37/share. You’ve committed to selling your shares at $33. You participated in the gains from $30 to $33, but have missed out on all gains above that.
The upfront premium and the lower break-even point (when the stock goes down) are the benefits you get for accepting a limit on potential profits.