I have written about covered calls before, as it is a strategy I have used for years, but this is my first covered call sell in the current iteration of my Undervalued Dividend Growth Portfolio.  The trade and post comes from being assigned 100 shares from the sale of a put contract last week.

What is a Covered Call?

Investopedia defines a call option as.

A call option is a contract that gives the buyer of the option the legal right (but not the obligation) to buy 100 shares of the underlying stock at the strike price any time before the expiration date.

Put another way, for a small amount of money up front today (premium) I am obligated to sell my shares anytime from now until the expiration date at a price certain.  The call is covered (as opposed to naked) when an individual actually owns the shares that he is obliged to sell under the previously described terms.

For me, options become alive when looking at an example.  Let’s say there is an imaginary company, ABC, and I own 100 shares (100 shares = 1 contract).  It is currently trading at $50/share, and I sell a covered call for .25 with a strike price of $60:

  • My account is credited $25.00 which represents the premium of .25 times 100 shares.  Regardless of what happens after this point I have my $25.
  • If ABC goes to $40/share by the expiration date what happens? I keep my $25 and the contract expires worthless.  Granted, I am now holding ABC at $30/share instead of $50, and maybe I would have sold prior to such a massive decline?  Although, maybe I wouldn’t if the stock was a long term, multi-year if not longer, hold.
  • If ABC goes to $100/share by the expiration date what happens?  I keep my $25 and my shares of ABC are sold at the strike price, $60/share.  I “lose” out on the gain between the strike price and the higher sale price.

The two extreme situations is why a lot of people have a problem with covered calls.  The premium isn’t enough to take on those huge swings, however, those are the exact reasons I like covered calls.

The Details of my Covered Call

I hope to one day make covered calls a larger part of my investment income strategy, but as indicated you need to hold 100 shares of a particular equity and since I am buying in drips and drabs of $500 that is going to take a good amount of time.  Notwithstanding, there is one situation where, from time to time, I am going to employ this particular strategy.

As described in some detail, I was assigned 100 Shares of Under Armour last week at $31.50 ($3,150.00), however the stock was worth less than that amount (on 11/7 the stock was worth $31.24/share ($3,124.00).  The easiest thing to do is to sell the stock and move on, but I believe in the underlying company (UA), so why  not wait for the stock to make a quick comeback?

My first covered call in this account was for UA to hit $32.00 within 4 days; I was paid $25 for this contract.    Two possible outcomes:

  • UA is above $32 by Friday – awesome I unload the stock I didn’t exactly want anyway but was assigned.  The sales price is higher than what I paid for it, so I will have made money on the put I sold, covered call I sold, and the actual stock sale.
  • UA is below $32 by Friday – awesome, I kept $25 and I will sell another weekly or maybe at a higher strike price and longer expiration date (wish I did more like $34 or $35 with a longer expiration date).

I am well aware that the numbers are small (the premiums), but they can add up over time.  This is especially true if I get a little tailwind on the underlying stock (in this case $UA).  If the stock isn’t called away on Friday and it is just under $32, I can then sell a contract with a higher strike price allowing for a higher gain on the eventual sale (and rinse and repeat).

Do you have any experience with selling covered or naked calls?