Covered Call strategies, a simple trading strategy that utilizes both equities and equity call options, can help to boost returns for traders by providing a cash flow stream. For stocks with dividends, it can be viewed as enhancing the dividend whereas for those without a dividend, it can be used to create an artificial dividend or lower the net cost basis of a position.
Covered call strategies employ owning a given stock and then selling an out-of-the-money call on that stock. By doing so, the investor caps their upside at the strike price plus the premium received by writing the call. However, the investor can use this strategy to create a cash flow on the stock.
Many investors will not buy a stock because it does not pay a dividend or may be reluctant to sell a stock due to the fact that they do not want to sell because it has gained so much that they have a large, unrealized tax liability. Thus, by selling calls, they can either create a dividend or extract cash flows from the stock in a more tax efficient manner.
The strategy is most effective when investors expect that stocks will move in a relatively sideways manner for the maturity term of the written call. Although the strategy does hedge against some downside in the stock price, it does not hedge out all of the downside. Therefore, it is not necessarily a hedging strategy but is better explained as cash-flow enhancing.
For example, assume that investor A owns 500 shares of XYZ stock worth $10,000.00 ($20 per share). In order to boost the cash flows of this position, A writes 5 call option contracts (one contract covers 100 shares so 500 total shares) which are bought by investor B for $1,500.00. Therefore, A has now created a buffer of $1,500 or 15 percent of losses against the position. Another way to look at it is that A just created an artificial 15 percent dividend payment on the stock contingent that the stock price does not fluctuate.
Investors are exposed to two types of losses in a covered call strategy. Because the strategy involves being long the stock, the investor is exposed to losses should the stock price drop although the buffer of the premiums received from the written calls serves to offset some of the first losses. Also, the investors faces opportunity costs should the stock rise above the strike price and the buyer of the call option chooses to exercise the option. In this case, the investor is forced to sell and gains are capped at the strike price plus the premium received.
Going back to the previous example, assume that the strike price on the options is $23 per share. Therefore, when the price rises to $26 ($23 is the strike price plus the $3 premium makes the break-even price $26), gains are capped at $6 per share or $3,000 (30 percent).
Again, covered call strategies should not be considered a hedging technique. Rather, it is a way to boost cash flows. Investors in stocks that either do not pay dividends or those with large positions or gains and do not want to sell could consider the strategy to extract cash flows. Also, the strategy is price sensitive and investors should consider the state of the market before implementing the strategy. However, all in all, the strategy is a great way for investors to boost cash flows and extract value from positions.
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