This Simple Income Strategy Could Produce 49% Annual Returns With Less Risk
Looking for an investment that generates 25% to 35% on average, without taking on too much risk? Using a covered call strategy can help you maximize income in your account while significantly reducing the amount of risk that traditional equity investors have to deal with.
Last week, we looked at a trade opportunity for Big Lots (NYSE: BIG) that had an expected 30.7% annualized rate of return. The trade involved buying shares of BIG at $35.87 and selling the April $35 calls at a price of $2 per share.
So far, that trade is working out just fine, with the stock trading in a stable pattern above the $35 strike price. For a basic understanding of how the covered call strategy works, check out that article.
As promised, today I want to take a closer look at which option contracts you should consider selling when setting up a covered call position. There are two primary variables that are important to consider when picking out which option contract to use:
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1. Strike Price: This is the price at which the owner of a call contract has the right but not the obligation to buy the stock from you.
2. Expiration Date: This is the date when the contract expires; after this date, the option can no longer be exercised.
Today, we’re going to look at the dynamics surrounding which strike price you want to use, and in my next article, we’ll take a look at the different expiration dates in play.
In the Money or Out of the Money?
Option traders use three different terms to categorize the strike price of the contracts: in the money, at the money and out of the money.
In-the-money call option contracts have a strike price that is below the current stock price. For example, our Big Lots trade had a stock price that was $35.87 and we were selling the April $35 calls.
These calls were “in the money” because the owners of the call contract could exercise their right to buy the stock at $35 and would be buying below the current market price for the stock. It would make sense for them to exercise this right before the calls expire because they can buy the stock at $35 and sell for a profit in the open market.
On the other hand, out-of-the-money contracts have a strike price that is above the current stock price. For example, if we had sold the April $40 calls for our Big Lots trade, these contracts would be out of the money, and the owner of the call would not want to exercise their right. (It wouldn’t make sense to buy a stock at $40 when you can buy it on the market for $35.87.)
All other things being equal, in-the-money contracts trade at higher prices, while out-of-the-money options trade at lower prices because they’re more likely to expire worthless.
Today, we’re going to look at a trade example that uses out-of-the-money call contracts and see what the difference is between the two approaches.
More Risk, More Return
As a general rule, covered call trade setups that use out-of-the-money contracts have higher potential returns, as well as a larger amount of risk. Remember, the covered call strategy is basically a trade-off. We give up the potential for huge gains, and in return we receive more reliable income, and some protection from a drop in the stock price.
When you buy a stock for a particular price and sell a call contract that has a higher strike price, you give yourself a chance to make a profit as the stock travels higher to match the strike price — and you still get to keep the premium for selling the call option.
The difference is that you receive less premium because out-of-the-money call options are priced lower. So this gives you less protection against a drop in the stock price.
Let’s take a look at a real-world example that you can put in your account today if you like. (Compare this trade to the one we discussed last week to see how our potential return is higher but our risk protection is a bit lower.)
Family Dollar Covered Call Writing Strategy
For today’s trade, we’re going to look at Family Dollar (NYSE: FDO) — another stock that caters to budget-conscious consumers. I picked this stock because it is in the same sector as Big Lots, our trade from last week.
These stocks trade with similar metrics and also have a similar stock pattern. This gives us a great comparison for seeing how the in-the-money and out-of-the-money contracts work differently.
To set the trade up, we will buy FDO stock in 100-share lots. The stock opened the week at $58.96, but your price might be slightly different depending on the market action. Next, we will sell the FDO April 60 Call contracts. These calls were trading at $1.50 at Monday’s open, but again, your price could be slightly different. You want to sell one call contract for every 100 shares of stock. Since we are buying the stock at $58.96 and selling the calls at $1.50, our net cost is $57.46 per share.
Now let’s look at the three different scenarios for how this trade can work out.
Scenario 1: FDO Trades Lower
Just as we did with the BIG trade, let’s first consider what happens if our stock trades lower by 10%.
A 10% drop in FDO is not likely, as improving consumer spending and a stronger employment environment should help propel this stock. But we still need to analyze the risk. If FDO drops 10% between now and the April expiration date, it will put the stock at $53.06.
With this scenario, we would get to keep the $1.50 that we received for selling the call, which would help to offset our $5.90 loss on the stock. Netting out the two sides, we would be out $4.40 per share for a 7.5% loss.
Under this scenario we would have less risk protection than if we had sold an in-the-money call, but you can see that we still reduced our risk significantly when compared to a traditional stockholder.
Scenario 2: FDO Trades Flat
Let’s assume that FDO remains flat between now and the April 19 expiration date. Under this scenario, the call option would expire worthless. This is because no one would want to exercise their option to buy FDO at $60 if they could buy the same stock in the open market for $58.96.
When the calls expire, we get to keep the $1.50 per share and we get to keep the stock itself. If you compare the $1.50 profit to our cost of $58.96, you get a 2.54% profit in about one month. Annualized out, this represents a profit of about 30%.
This annualized profit makes sense because we can immediately turn around and sell another option contract against the stock that we still own. So we may decide to sell the May $60 calls against the position for a similar expected return.
Scenario 3: FDO Rallies
Under the final scenario, if FDO trades higher, we get to participate in the gains for the stock and we also get to keep our $1.50 that we received for the call options. If FDO trades 10% higher, we won’t realize the full 10% gain. After all, we have sold someone else the right to buy the stock from us at $60. But we have been well compensated for selling that right.
Under this scenario, our maximum gain is $2.54. This represents the $1.50 that we received from selling the calls, and another $1.04 in profit as the stock rises from our purchase price of $58.96 to the strike price of $60. This $2.54 profit is a 4.31% gain over our cost of $58.96. Since this trade only takes a little over a month to complete, we are effectively receiving a 49% annualized return.
As you can see, this is a higher annualized return than the 30.7% that we were able to set up with the Big Lots in-the-money trade. This is because we received profit not only from selling the call contract, but we also received part of the profit from the stock rallying.
Which Option Contract to Pick?
When deciding between an in-the-money covered call trade or an out-of-the-money setup, there are a number of different factors to consider.
Looking specifically at the stock, you need to run the numbers on how much return and how much risk protection each contract gives you. You also need to look at the fundamentals and the technical aspects of the stock to determine the likelihood of the stock finishing above your strike price. Beyond the individual stock, it’s a good idea to look at other stocks in the industry, and also the state of the overall stock market.
In times of higher risk and more volatility, it is usually best to err on the side of caution. You may want to sell more in-the-money calls that offer less income but more protection. And then, of course, when the tone is bullish, you can sell out-of-the-money calls, which still give you protection, but increase your potential returns.
Over the next several weeks, we’ll continue to look at additional trade examples that you can put directly into your portfolio and measure your success.