By Jeff Brown | Contributor for U.S. News & World Report
Aug. 29, 2016, at 9:18 a.m.
If stocks, bonds and mutual funds are the inner planets from Mercury through Mars, options trading is out there beyond Neptune, a dangerous place for ordinary investors. Except for writing covered calls, a comparatively safe options strategy for earning extra income on your stocks or exchange-traded funds.
While most plain vanilla investors know nothing about writing covered calls, this is actually the most common stock option strategy, and advocates say more ordinary folk should give it a try.
“If you own 100 shares of stock and are not writing calls against them every month, then you’re just leaving money on the table,” says Mike Scanlin, CEO of BornToSell.com, a website serving covered-call writers.
Among the numerous benefits, he says: the strategy can “reduce risk, lower portfolio volatility, generate monthly or weekly income on stocks you already own.”
And, he says, it “pays way better than interest on cash, and way better than bonds.”
Of course, not all experts are as enthusiastic.
“Option writing can be very confusing for inexperienced investors,” says Sterling D. Neblett, founding partner of Centurion Wealth Management in McLean, Virginia.
He notes that although writing calls is common among options traders, most investors avoid options altogether. “In fact, many financial advisors are not very comfortable trading options,” Neblett says.
“Covered call writing is the stock market equivalent of putting a renter in a piece of real estate that you own,” says John Fowler, wealth manager at McElhenny Sheffield Capital Management in Dallas.
“Covered calls are a great way for income investors to double up or triple up on the yield of their underlying stock or to turn a non-yielding stock into an income generator,” McElhenny says.
To understand writing covered calls, you must first know the basics of stock options. For a fee called a premium, an options owner gets the right to buy or sell 100 shares of a specific stock at a set price for a given period of days to months. The person who receives the premium agrees to buy or sell those shares if the options owner decides to exercise the option.
The covered-call writer is the person who creates the option, promising to sell if the purchaser exercises. If you owned 100 shares of XYZ Corp. currently trading at $10 a share, you might sell an option for $1 a share promising to sell all 100 shares for $10 each – the “strike price” – anytime through the end of the year. If XYZ went to $12 the options owner could exercise and buy your shares for $10, netting $100 after selling the shares and accounting for his $100 in premiums. As the call writer, you would earn the $100 premium and get $10 a share. (In real life the premium would probably be much smaller.)
So the first issue is are you willing to sell at the price specified in the options contract? Because if the options owner exercises, you’ll have no choice; the transaction will be handled by your broker. In the example, you’d miss out on $100 – the $200 in price gain less the $100 earned in premium.
However, there’s a remedy if you’re reluctant to sell. That is to write a call contract that is “out of the money,” or currently seems unlikely to be exercised because it would be unprofitable for the options investor.
You could, for instance, write a contract with a strike price of $13, figuring XYZ isn’t likely to go that high. Because this contract is less likely to make money, the premium would be much lower. But if you could get, say, 25 cents per share in premium, you’d make $25 and most likely be able to keep your shares, since the option buyer would not buy at $13 if she could buy for less in an ordinary trade. By declining to exercise, the option buyer would be out $25, and you’d be $25 richer.
This is how covered call writers earn income from their stock holdings. It can also be done with exchange-traded funds, but not with ordinary mutual funds.
The chief disadvantage of call writing, Scanlin says, is if the options buyer exercises, you miss any further gains.
“A conservative covered call investor typically buys a diversified portfolio of large-cap, dividend-paying, blue-chip companies and then writes one- to three-month calls against them,” he says. “You can earn 3 percent per year from dividend yield, and then another 6 to 10 percent per year in call premium, for a total of 9 percent to 13 percent” he says.
Plus you’d enjoy any price gains on the stock if the options were not exercised. Over time, premium income helps offset any loss if the share price declines, reducing the risk in the portfolio, Scanlin says.
There’s an escape hatch, too. If the stock price soars and you don’t really want to sell at the strike price, you can buy a call option from someone else to offset the one you’d written. Note, though, that premiums are set by supply and demand in the marketplace, and go up if the option at a given price becomes more profitable. So it could be quite expensive to wriggle out of your obligation.
Premiums are also higher if the option’s deadline is further away, and if the stock price is especially volatile.
“Most of our customers are self-directed investors age 50 or higher who want more monthly income from their portfolio of stocks than dividends alone provide,” Scanlin says.
He also warns that people accustomed to buy-and-hold investing with mutual funds are not ideal candidates. Options trading takes the kind of close attention and stock analysis more common among active stock traders, because the call writer must figure the odds share price changes.
By continuing to own the shares, the call writer continues to risk loss from falling share prices, Neblett says, cautioning that writing calls is not for everyone.
“Candidates who are expecting significant appreciation from their stocks and do not want to limit the upside potential of their stock positions should not use this strategy,” he says.
“It’s worth noting that the call option market is very efficient and there’s rarely, if ever, a free lunch,” says Rahul Ray, principal at Burr Capital in Edgewater, New Jersey.
Although the prospect of extra income is alluring today, writing calls tends to be less profitable when stocks are less volatile and rising, as they are now, he says.
While the stock market has gone up over time, producing profits for investors who stick out the downturns, options trading is less forgiving, because investors are betting against each other. So for every investor who makes money there must be one who loses an equal amount.
Before joining the game, experts say, think about whether you are as smart and hard working as your competitors.