Please refer to Important Disclosure Information at the end of this research note.
Covered call writing is a low risk strategy to enhance yield and lower cost basis. The latter benefit may be appealing in today’s arguably overvalued equity market.
It’s perhaps easiest to understand the mechanics using a real example. Say you own shares of Discover Financial (DFS), a company with a relatively deep and liquid options market. The shares are trading at around $58 with a 2.1% dividend yield. You can sell one covered call for every 100 shares you own. If you sell the $65 strike price, 10/21/2016 expiration, you can collect around $5 for a 0.1% yield. You can repeat the process 6 times in a year for a 0.5% annualized yield.
If your options expired out of the money, you would’ve realized an overall yield on DFS of 2.6% versus a straight 2.1% dividend yield. To increase the yield further, you could pick a lower strike price or a longer expiration.
If DFS shares rise above $65, to say $100, by 10/21 then the options will be exercised against you and you will have to sell your shares at $65, capping your gains. So by selling a covered call you’re trading off capital appreciation potential for a modest current yield.
Here's a list of pros and cons.
- Covered calls are an easy to implement, low risk way to enhance current income.
- They can be implemented in most retirement accounts and many brokerage firms even provide easy drop down menu options so that one could sell covered calls without a deep knowledge of option Greeks (Delta, Gamma, Theta, etc.) and chains.
- When volatility is elevated and the markets are heading lower, the strategy can act as a speed breaker.
- If you believe the underlying shares are fairly valued but you’re not quite ready to sell the position then selling covered calls can be a better alternative to holding cash.
- It’s worth noting that the call option market is very efficient and there’s rarely, if ever, a free lunch. So while in theory covered calls are more appealing in today’s low yield market, in practice, the low volatility and rising market make covered calls less attractive. This can be easily seen from the above example where we created a low 0.5% yield on DFS using covered calls. In contrast, we could’ve created a 3.5% annualized yield earlier in the year when volatility was much higher.
- Covered call writing can tie up more capital for longer than one would like. If the underlying shares rise then the mark-to-market losses on the call option will offset the gains on the shares so if you close the position before the expiration date, when the call option is underwater, you may risk losing the premium you collected when you initially sold the covered call.
Important Disclosure Information
At the time this report was submitted for publication, the principals and clients of Burr Capital LLC owned securities issued by Discover Financial (Ticker: DFS).
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