Jeff Carter, Senior Editor
Two Ways to Increase Your Covered Call
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
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.