The Complete Option Report

Two Ways to Increase Your Covered Call Returns
by Jeff Carter

Selling (writing) covered calls in one of the most basic and also the safest of all option strategies.

You can generate additional income from stocks that you own, and this income helps hedge against the risk of owning the stocks.

But in order to write a covered call, you must first own at least 100 shares of the underlying stock.

This can develop into a large out-of-pocket expense. And in this era of level stock prices and extremely low interest rates, investors accustomed to the returns generated by stocks during the late-nineties may be disappointed by the lower returns generated by covered call writing.

However, as with all option strategies, there are ways to use covered calls to produce much larger returns.

Naturally, in return for the possible larger gains you will take on more risk. If you are comfortable with that, and consider yourself a nimble trader, here are a couple twists you can apply.

One twist is to write the call without owning 100 shares of the underlying stock. In other words, write an uncovered, or “naked,” call. At the same time place a contingent buy order to purchase the stock at the strike price of the call. (Not all brokerages allow this trade, so be sure yours does before you try this.)

The contingent buy order is a necessary ingredient. A stock theoretically can rise to infinity, which makes naked call writing a risky venture.

If you are assigned a naked call you may be required to purchase the stock for substantially more than what your covered call allows you to sell it for. But by using a contingent buy order, should the stock rise above the strike price you will automatically purchase enough shares of the stock to make your written call “covered.”

A contingent buy order requires that you have the funds readily available to purchase the stock if you are required to do so. So in that regard the contingent buy order operates like a margin account, with one vital difference. If necessary, you will have to pony up money to buy a stock that is moving in your direction, not against you.

This tactic also has another advantage. If the stock moves lower you will not have invested money in a declining stock. You will simply have pocketed the income from writing the call.

The second twist is to pay less for the shares of stock. You can do this by buying the stock on margin.

Buying stock on margin involves taking a loan from your broker, then using the loan to purchase stock. Currently it is possible to borrow up to 50% of the cost of the stock. This in turn doubles your percentage return from writing covered calls against the stock.

For example, a covered call that generates a 6% return against shares of a stock that is fully paid for would generate a 12% return against shares of a stock that were financed with 50% margin. This return percentage is reduced by the interest rate of your margin loan.

Be aware, though, that buying stocks on margin is risky. Primarily, if the stock goes down, you are losing money at a much faster rate than you would had you paid full price for the shares.

Not only are your stock shares losing value, but your stock shares serve as collateral for your margin loan, so the amount necessary to repay your loan is increasing.

And while your covered call may not be in danger of being assigned, you will be more likely to receive a margin call from your broker, which could obligate you to close the position at an inopportune time.

Contingent buy orders and buying stock on margin are aggressive ways to use covered call writing to your advantage. If you are a nimble trader they are worth looking into. But if you value safety first, stick to traditional covered call writing.