Short-Term Out-of-the-Money Covered Calls

I periodically employ a conservative ‘out of the money covered call’ option strategy when I think I can generate some option premium income and I have a strong probability of retaining the underlying security.

In recent articles I have expressed my concern with respect to the behavior of the North American equity markets during this time of crisis. In my opinion, all is not well and the broad increase in equity prices throughout April is attributed to FOMO (the fear of missing out).

We are a long way from finding a vaccine for COVID-19 and with several countries deciding to ‘open up’ I envision a surge in COVID-19 cases. Regretably, this will very likely lead to a surge in the number of COVID-19 deaths.

Looking at this data, I have very serious reservations that we will witness any ‘flattening of the curve’ in North America in the foreseeable future. This will likely result in many consumers and businesses further ‘pulling in their horns’ and dramatically curtailing their spend.

I fully agree with Warren Buffett that it is ‘impossible to know exactly what happens when you voluntarily shut down a substantial portion of your society‘ but I am willing to out go out on a limb and to take the position that the broad North American equities market will weaken over the short-term.

As a long-term investor I am not prepared to liquidate all my holdings in the hopes of being able to repurchase shares in the future at a lower price. I am, however, prepared to write short-term ‘out-of-the-money covered calls’ on some of my holdings; I have successfully employed this strategy on several occasions and have disclosed my trades in previous articles.

By employing this conservative option strategy I am prepared to grant another investor the right to acquire my shares at a predetermined price within a specific timeframe. In exchange for granting this right, I collect an upfront premium.

Ultimately, my intent is not to part with my shares so I want the price of the underlying shares to stay below the strike price of the options I wrote; my intent is merely to increase my cash flow. I really do not care if the price of the underlying shares drops since I am a long-term investor and would not have sold my shares had I not employed this conservative option strategy.

Covered Calls

On May 4, 2020 I wrote the following covered call contracts (each contract represents 100 shares) with a June 19, 2020 expiry date:

  • Chevron Corporation (CVX) 10 contracts with a $100 strike price and received $1.42/share.
  • Walmart Inc. (WMT) with a $140 strike price and received $0.78/share. *
  • Becton, Dickinson and Company (BDX) with a $280 strike price and received $1.70/share. *
  • Visa Inc. (V) with a $195 strike price and received $1.41/share. *

Trades denoted by * are held in accounts for which I do not disclose details, and therefore, I am not disclosing the number of contracts written.

I am employing this conservative option strategy because I think the share price of the underlying securities will remain below the strike price of the options written. If this ends up happening, I retain the underlying shares and the option premium I have collected.

If, however, the share price of the underlying security exceeds the strike price come expiry, I would need to relinquish my shares. I certainly have no intention of parting with the underlying shares so I would repurchase the option contracts to close the positions. I could potentially suffer a loss if the amount required to close the positions exceeds the amount I collected when I wrote the contracts.

To determine my breakeven value, add the option premium to the strike price. In the case of CVX, I breakeven if the share price remains below $101.42/share. (NOTE: this breakeven price excludes the impact of nominal trading commission).

FYI – An option contract consists of intrinsic and time value and an explanation of how options are prices can be found here. Note that the expiration of time works in favour of an option seller and the decay of the time value of an option increases as we approach expiry.

Final Thoughts

I am cautiously optimistic the option contracts disclosed above will expire worthless at which time I will decide how to deploy the funds generated from writing these covered calls.

With further luck, I hope equity values will come under pressure over the next several months thus providing investors with the opportunity to acquire shares in high quality companies for the long-term.

Stay safe. Stay focused.

I wish you much success on your journey to financial freedom!

Thanks for reading!

Note: I sincerely appreciate the time you took to read this article. Please send any feedback, corrections, or questions to [email protected].

Disclaimer: I have no knowledge of your individual circumstances and am not providing individualized advice or recommendations. I encourage you not to make any investment decision without conducting your own research and due diligence. You should also consult your financial advisor about your specific situation.

Disclosure: I am long CVX, WMT, BDX, and V.

I wrote this article myself and it expresses my own opinions. I am not receiving compensation for it and have no business relationship with any company whose stock is mentioned in this article.