Writing covered calls: A strategy similar to collecting rent

12 December 2018 by Richard Ho
writing covered calls

Owning an income property has its pros and cons. As a landlord, it gives you the right to collect monthly rent. You can also offset your rental income by using the property’s related expenses. Plus, the property has the potential to grow in value. Owning a rental property is a winning strategy on many levels. 

But there are also some downsides to owning a rental property, such as tenant risk. There are no guarantees that tenants will pay the rent on time and you might even have to take them to court to evict them. Some landlords are constantly sending over handymen to make countless repairs. Another drawback to owning a rental property is the illiquidity and concentration of the asset. Plus, you need to tie up a large portion of capital for the down payment and pay off the mortgage over 20 something years. Also, don’t forget about the property taxes, school taxes, and insurances that come into play. Picture this, you are a landlord, it’s in the middle of the night and it’s -20 °C outside. One of your tenants calls to report that the water pipes just burst or that the fridge is not working. This is not the type of call anyone would like to receive at 2 o’clock in the morning.

However, there is an alternative to the rental property strategy. By having an options trading account, you can “rent out” your stocks to collect monthly (or even weekly) income in the comfort of your own home. This strategy is allowed in both registered and non-registered trading accounts.

This option strategy is called covered call writing. You need to:

1)    Buy a stock that you like. (Just like a property, you want to buy something that will maintain or increase in value.)

2)    Set a price at which you would like to sell your stock. (Think of this as a promised price at which an investor could buy your property.)

Rental property
Purchased price of the property:
$800,000

Promised selling priceto the investor:
$900,000 

Monthly income:
$2,000 

 

OU

Covered call
Stock purchase price:
1,000 shares at $10 ($10,000)
Promised selling price
(strike price):
$12 
Premium from the sale* of one-month call options:
10 x 100 x $0.30 = $300 

*For every 100 shares you own, you can write one call option.

In your trading account, buying a stock is easy. Simply place a buy order, enter the symbol, the quantity of shares, and a price. For the option part, you will “sell to open” a call option, but it will be “covered” by the shares you own which will serve as collateral for the calls that you are selling.

Possible outcomes from the covered call strategy

Stock purchase: $10.00

Call premium: $0.30 (3% yield on the stock price)

Strike price: $12.00 (20% potential capital gain)

Return on investment (ROI): potentially 23% in 1 month

Scenario Stock price at expiry
Profit/Loss
ROI*
Stock goes up a lot
$15.00
$12.30
23,00%
Stock goes up modestly
$12.50
$12.30
23,00%
Stock stays the same
$10.00 $0.30 3,00%
Stock drops modestly
$9.00 -$0.70
-7,00%
Stock drops a lot
$8.00 $1.70
-17,00%

*All performance calculations are based on a one-month period.

This strategy consists in writing a call that is covered by an equivalent long stock position. It provides a hedge to the extent of the call premium received and allows you to earn premium income in return for temporarily forfeiting the stock’s upside potential over the strike price.

In conclusion, the primary motive of this strategy is to earn additional income on a recurrent basis, which has the effect of boosting overall returns on the stock and providing a measure of downside protection. The best candidates for covered call writing are stock-owners who are perfectly willing to sell their shares if the stock rises and the calls are assigned.

To learn more, visit m-x.ca/education

By Richard Ho, CAIA, DMS, FCSI, Senior Manager—Equity Derivatives

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