Great companies sometimes become grossly overvalued yet we do not want to part with the underlying shares. In such instances, skim additional income with covered calls.
A covered call:
- is a conservative options strategy used to generate income if you think the underlying stock price is unlikely to rise significantly within a specific time frame;
- consists of holding a long position in a stock and then selling (writing) call options equal to the same number of shares as the underlying long position.
- limits the potential upside profit and does NOT offer much protection if the price of the underlying stock declines.
A covered call writer sells the right to another investor in exchange for cash (option premium). The option buyer has the legal right, not the obligation, to buy the underlying stock at the strike price any time on or before expiration; each option contract equals 100 shares.
If the call option seller also owns the underlying security, this option is 'covered'. This is because the option seller can deliver the instrument without purchasing it on the open market.
Skim Additional Income With Covered Calls
The option buyer pays the option seller a premium for the right to buy shares at a predetermined future price by a predetermined date. The premium is paid the day the option is sold and is retained by the option seller whether the option is exercised or not. A covered call is, therefore, most profitable if the stock rises to the strike price and the call expires worthless.
Covered Call Advantages
Selling covered calls helps offset downside risk and/or adds to upside return. Let's use my recent Nike (NKE) covered calls as an example.
In my Nike, Inc. – Employing a Conservative Options Strategy on Richly Valued Shares article I disclosed that I had written 5 out-of-the-money covered call contracts with a $155 strike price to expire March 19, 2021. I wrote the option contracts on February 3rd at which time Nike was trading at ~$138.30. This trade generated $0.98/share or $490 before nominal trade commission.
These option contracts expired worthless because NKE's share price remained below the $155 strike price; I retain the option premium I collected and I still own the underlying shares.
NKE is currently trading at ~$134.25 so the value of each underlying share is ~$4.05 less than when I wrote my options contracts. I collected $0.98/share before nominal trade commission so the decline in value of each NKE share from the date I executed my options trade is only $3.07.
Covered Call Risks
Covered calls do not always work out as planned. Let's use my Chevron Corporation (CVX) covered call trade as an example.
On February 2nd I wrote Chevron Corporation – Increase Income Using Short-Term Out-of-the-Money Covered Calls. I wrote 11 contracts to expire on March 19th with a $100 strike price. Shares were trading at ~$87 so I thought a ~$13 buffer between the current share price and the strike price would be sufficient to limit my risk of the option buyer exercising their right to acquire some of my CVX shares. Such was not the case!
CVX's share price went on a tear and in my February 25th Nike, Inc. and Chevron Corporation – Covered Calls Update post I indicated that I had decided to take my lumps and to close out my CVX position at a loss. I think it is a good thing I did this because CVX's share price rose to ~$112 by mid-March. Had I not closed out my position, the option buyer could have exercised their option to acquire my CVX shares at $100.
While I lost money on the option trade, I made up most of that loss from the CVX dividend income I collected on March 10th. I also still own the underlying shares and they are now trading at ~$103.
New Covered Call Trades
Mastercard Covered Calls
On April 8th, I wrote 5 May 21, 2021 Mastercard (MA) covered call contracts with a $420 strike price. I generated $2.09/share or $1045 for the 5 contracts before the nominal commission.
Other investors may prefer a strike price much closer to the ~$380 price when I wrote the option contracts. This would have generated more option premium.
My concern, however, is that even though I think MA shares are grossly overvalued, not every investor shares my sentiments. It would not surprise me if MA's share price were to appreciate well above the current market price between now and May 21. I do think, however, the $420 strike price provides a sufficient buffer so I need not monitor MA's share price daily.
Looking at FY2011 - FY2020 diluted EPS we see: $1.48, $2.19, $2.56, $3.10, $3.35, $3.69, $3.65 ($4.58 adjusted), $5.60 ($6.49 adjusted), $7.94 ($7.77 adjusted), and $6.37 ($6.43 adjusted). Keep in mind that adjusted diluted EPS guidance is generally higher than diluted EPS when assessing MA's valuation.
Using my two online trading platforms I see FY2021 adjusted diluted EPS guidance of $8.07, $7.28, and $8.91 (mean, low, and high) from 40 brokers.
MA was trading at ~$380 when I wrote my covered call contracts on April 8th so based on the $8.91 high guidance, the forward adjusted diluted PE is ~42.65! MA might be a great company but a valuation at this level is, in my opinion, irrational. Current market conditions, however, are irrational and I do not want to tempt fate; I think a ~$40/share buffer between the current share price and the strike price is appropriate for my risk tolerance.
Visa Covered Calls
On April 8th, I wrote several June 18, 2021 Visa (V) covered call contracts with a $260 strike price when shares were trading at ~$220. VISA is my largest holding and shares are held in an account for which I do not disclose details so I will not disclose the number of contracts I wrote.
Looking at FY2011 - FY2020 diluted EPS we see: $1.29, $0.79, $1.90, $2.16, $2.58, $2.48, $2.80 ($3.48 adjusted), $4.42 ($4.61 adjusted), $5.32 ($5.44 adjusted) , and $4.89 ($5.04 adjusted). As with MA, adjusted diluted EPS is typically greater than diluted EPS so we need to keep this in mind when determining V's forward valuation.
Using my two online trading platforms I see FY2021 adjusted diluted EPS guidance of $5.51, $5.19, and $5.80 (mean, low, and high) from 41 brokers.
Based on $5.80 high guidance, the forward adjusted diluted PE is ~37.93! V might be a great company but a valuation at this level is, in my opinion, irrational. Once again, I do not want to tempt fate and think a ~$40/share buffer between the current share price and the strike price is appropriate for my risk tolerance.
Each option generated $0.55/share or $55/option contract.
You can see VISA's volatility is far less than that of Mastercard because:
- I have a $40 spread between the current share price and strike price for both V and MA;
- I have gone out further on the calendar for the V options;
- The V premium per share is only ~26% of the MA premium.
Once again, I intend to merely 'skim' additional income. I am not trying to 'hit a home run'. Furthermore, given the number of V contracts written, I generate more option income from my V contracts than my MA contracts.
Skim Additional Income With Covered Calls - Final Thoughts
I have been able to skim additional income with covered calls with a reasonable degree of success. As demonstrated with my CVX covered call trade, however, the best-laid plans can go awry. I, therefore, purposely do not want to select strike prices that are too close to the current share price. I have also purposely selected expiry dates that are not far out on the calendar. This way the time value of each option will start to expire relatively soon which works in my favour.
I wish you much success on your journey to financial freedom.
Thanks for reading!
Note: Please send any feedback, corrections, or questions to [email protected].
Disclosure: I am long NKE, CVX, MA, and V.
Disclaimer: I do not know your circumstances and am not providing individualized advice or recommendations. You should not make any investment decision without conducting your research and due diligence.
I wrote this article myself and it expresses my own opinions. I do not receive compensation for it and have no business relationship with the company mentioned in this article.