Stock Talk #11: Using Short-Term Vol To Your Advantage Through Covered Calls
Short Stock Talk today on a protective trade I think is really nice for today’s environment. The covered call is a way of collecting a premium when buying a stock in exchange for capping your upside.
Before moving on, I think it’s important to explain why anyone would ever make a trade that caps their upside. If your trading strategy is to buy low-cost ETFs and set it and forget it for decades (which to be clear is perfectly fine and what I do with most of my portfolio), then don’t read this post. However, if you have some names you’re thinking about buying but are not feeling near-term bullish on or want a less risky set of payoffs based on the stock price, read on. Additionally, if you’re trying to dollar cost average into the market, covered calls can effectively reduce your average buying price (with the tradeoff of a potential cap on profits – more on this below).
Covered calls makes your potential payoffs relative to the stock price look like the graph below in comparison to just buying the stock (you can change the inputs here by copying the linked Google Sheet):
The trade involves only one difference from just buying stock; you also sell a call option. A call option represents the right to buy stock (for one contract, 100 shares) before a specific date (known as the expiration, or expiry) at a certain price (known as the strike price). In the example above (completely made up), the strike price is $5 and let’s assume the expiration date is May 14.
Because a call option represents the right to buy before a specific expiration date at a specific price, a number of outcomes can happen on that date. In the example above:
– If the stock is below $5 on May 14th, I get to keep my premium. The option I sold is worthless and can’t be exercised. I make the premium, but on paper I may be losing money (ex. if the stock is now at $4, I’ve lost $1 on paper, offset by the $1 premium, so $4 is breakeven in the example above)
– If the stock is above $5 on May 14th, I still get to keep my premium, but I have to sell my 100 shares to the person I sold the call option to (because they have the right to buy at $5). I bought the stock at $5 and sold at $5, so I’m even on that trade, and make the premium ($1) from selling the call option
Option prices are more volatile than stocks and depend on a variety of factors, but one central factor is implied volatility, or, roughly, how volatile market participants expect a stock to be in the future. One measure of this for the implied vol of the S&P 500 is an index called the VIX.
As you’d expect during Coronavirus, the VIX has traded higher than the last several years of the previous bull market:
As a result, options are more expensive now than they were on average of the last several years. Covered call trades have higher returns than they previously had, since option premiums are now higher. In the graph above, notice how the trade starts underperforming just buying the stock at $6 and has downside protection to $4. If I double the premium from $1 to $2, the covered call outperforms the stock up to $7 and has downside protection to $3:
There’s a ton of good resources for modeling out covered call trades, and I want to recommend two:
– Options profit calculator – looks very 90s website-y but gets the job done. Enter your inputs and it will build payoff graphs for you
– Fidelity’s options strategies – a friend of mine just recommended this yesterday and I’ve found it helpful for idea generation. Note that sometimes covered call trades are referred to as “buy and write” strategies (buy the stock, “write” (i.e. sell) the option), which is what Fidelity calls it
It’s also worth noting that there are a good amount of protective options strategies like this (ex. married put) where you buy or sell an option along with buying stock to either protect your downside or collect a premium or both. Nothing is free; options trades like this always decrease your *maximum* potential return relative to just owning the stock, but there’s some range of prices where the option strategy outperforms the stock. In our example above with the $2 premium, the covered call outperforms the stock below $7 when you buy the stock at $5.
One final note – for small cap stocks and even some midcaps, options can be extremely illiquid and often not worth trading because the bid-ask is so wide. I would only recommend this strategy for large cap names where there’s an active options market.
I’m considering using covered calls for new names I want to buy over the next few months. Shoot me an e-mail if you find any trades you like.