Writing Covered Calls To Protect Your Stock Portfolio

Reduce the Risk of Your Portfolio And Protect Yourself From a Rainy Day By Selling Call Options

This bull market continues to chug along despite Europe’s teetering economy and the on-again off-again trade war with China. Nobody knows what will happen next or whether markets will finally experience an extended downturn at some point.

But it doesn’t hurt to take some money off the table while stock prices are still near all time highs. Here is a reasonably safe method for taking some profits and reducing your risk while at the same time still preserving some upside exposure.

Let’s say we have been investing in Apple for quite some time and are sitting on sizable gains. We believe in the company and think that the current valuation is somewhat stretched but reasonable when compared to other big tech stocks.

We can protect ourselves somewhat by selling (finance folks call the act of selling options “writing”) call options against our Apple stock position. When we do this, we are trading upside for protection — we receive some money for selling the call option but in return, we lose out on any money we would have made if Apple’s stock price moves above the strike price on our option. Let’s go through this with an example:

• The current price of Apple as of this writing is $208.74. Assuming we own 100 shares, that means we have $20,874 invested in Apple stock, a sizable amount.
• Three years ago, the price was $107. That’s a 95% return in three years, not including dividends. So assuming we’ve owned it for a while, then we should be sitting on some decent sized profits.
• The last quoted price for an Apple call option, with a strike of $220, expiring on 11/15/2019 was $630. This is the premium, or amount of money, we would receive if we were to sell this call option.

That’s a lot of finance lingo, especially in that last bullet. Let’s walk through what it all means. When we own stock, like our 100 shares in Apple, our payoff diagram looks like the one depicted below.

The Y axis is the profit or loss of our investment and the X axis is the current price of the stock. The blue line shows our profit or loss as a function of the price of the stock (in our case, Apple).

Since we own 100 shares of Apple, when the stock price increases (moving right on the X axis), our profit increases also (moving up on the Y axis), so the up and to the right direction of the blue line makes sense. For the mathematically detailed, a $1 increase in the price of our Apple stock would translate to a $100 increase in the profit of our position (since we own 100 shares).

The vertical gray dashed line denotes the price at which we purchased our Apple shares. If the current stock price is higher than our purchase price, then the Y axis value of the blue line is above the blue “0”, denoting a profit. If it is not, then we are sitting on a loss.

Now let’s see what happens when we add call options to the mix. First let me quickly cover the nitty gritty of how options work:

• An option is a financial instrument that grants you the right, but not the obligation, to either buy or sell 100 shares of a financial asset (such as Apple stock) at a predetermined strike price.
• Options have expirations. That means that after the expiration date, they cease to exist, poof (for example, our Apple option expires in about 2 and a half months on 11/15/2019).
• But at any time prior to expiration, if you own the call option you can choose to pay the strike price to buy the shares of the underlying stock. Generally, you only want to do this if the stock price is higher than the strike price (if it is, you are effectively buying the stock at a discounted price).
• If you work in tech, you probably already own some really long duration options on your employer’s equity. Lucky you!

Let’s look at what buying and holding a call option looks like on our payoff diagram (below). Notice that there is now a kink in our blue payoff line. The way the line flattens out at the strike price as we move left on the diagram means that our losses are capped at the premium (the price we paid for our call option). This is an attractive aspect of investing in options — the knowledge that regardless of what happens, our losses are capped at the premium. The other aspect of call options that investors love is the unlimited upside. Notice that as we move right on the diagram our blue payoff line goes up in the same way as it would if we owned the underlying stock. This means that by paying just the premium, we end up getting the same economic exposure that we would have if we had bought the underlying stock outright (when the stock price is greater than the strike price).

On the other hand, one disadvantage of owning call options is that unlike with buying stocks, if the underlying stock price doesn’t move at all, you still take a loss since you are out your premium (also call options don’t pay dividends even if the underlying stocks do).

Additionally, there are also the added dimensions of time to expiration and the fact that the rate at which your option’s price changes is itself not constant and a function of many things (for example if our strike price is much higher than the current market price and the option is close to expiring, then even a large increase in the price of the underlying stock may not change the value of our option much) — these factors make options investing much more complicated than it appears at first glance. If you plan to jump into options investing whole hog, you must understand how all of these additional factors work before doing so.

If you sold a call option instead, which is what we want to do in our example, everything works in reverse. In this case, we have sold to someone (for a price) the right to make us buy 100 shares of the underlying stock at the strike price. Since everything is in reverse, we are now forced to take a loss if the stock price moves above the strike price on the call option we sold — in this case, the person who bought the option from us would force us to sell him or her 100 shares of the underlying stock for a price lower than the market price of the stock (so we are forced to sell at a discount).

The graph to the left shows the payoff diagram for writing (a.k.a. selling) a call option. It’s pretty much exactly the reverse of the previous one. Notice that the blue payoff line now starts above $0 for low stock prices all the way up to our strike price. This means that as long as the market price of the underlying stock is below the strike price of our option when it expires, we get to keep all of the option premium (the money we got for selling the option). Also observe that the premium is the maximum amount we can gain from selling a call.

Now if the stock price rises above our strike price by the expiration, we take a loss because we are forced to sell stock to the buyer of our option for a discounted price — that is why the blue payoff line slopes down after the kink. Notice that the potential loss is uncapped — if the price of the stock keeps going up then our losses would keep going up along with it. So selling call options provides limited upside while exposing us to unlimited downside (scary!).

Yes it is scary, but I am definitely not recommending that you write naked calls (selling calls without first owning the underlying stock, and yes it really is called that) as doing so on the wrong stock can be devastating. For example, imagine if you sold one 11/15/2019 (the expiration) Amazon call option at a strike price of $1,940. That’s about 10% above the current market price. For selling the call, you would receive a cool $3,300. Pretty nice right? But if Amazon returned to its 52 week high of $2,050, you would be forced to sell 100 shares of Amazon at $1,940. And since you sold a naked call, you would need to buy 100 shares at $2,050 and then immediately sell them for $1,940 — a loss of $11,000. So your total P&L (profit and loss) is:

• Received premium of $3,300 for writing the option.
• Took a loss of $11,000.
• For a net loss of $7,700… ouch!

We don’t want to be exposed to that kind of risk so writing naked calls are out of the question. But writing covered calls (selling call options when you already own the stock) in a richly valued stock market can be a risk reducing and potentially attractive trade for risk averse investors. Let’s see how in the next section.

Since we don’t want to sell calls naked, what we want to do is to only write (remember that write means sell in financial markets) call options on stocks we already own at least 100 shares of. The way I personally think about writing covered calls is that it’s like:

Making a promise to sell your stock if it hits a certain price (or goes up a certain amount) and being paid for making that promise.

Prior to entering any transaction, we need to decide the following:

• At what price are we OK with having this stock called away from us (by the buyer of our option) — that decides what strike price we choose. The higher the strike price, the less money we would receive for writing the option. This is similar to deciding something like, “if the stock goes up 10% from its current price, I will sell it” with the added sweetener of also earning the option premium (the money from selling the call).
• Over what timeframe are we comfortable taking on this risk. The further out the expiration date of our option is, the more risk we assume, and the more money we receive for writing the option. Our risk is higher from a longer duration option because it is easier for Apple to go up 10% over a year’s time than it is for Apple to go up the same amount in just a month’s time. There are many strikes to choose from ranging from options expiring in just a few days to ones expiring in 2 years.

It’s important to realize that these two decisions are connected. If you write a call option expiring in 2 years, then you would want to set your strike price at least 20% above the current market price, otherwise you are all but ensuring that your stock will be called away. On the other hand, if you write a call option that expires in one week, you don’t want to set the strike too far above the current market price, because then you would receive almost no premium for your troubles.

The premium that you receive for selling a call option is a function of how likely that, at expiration, the market price of the stock will be above the strike price of your option.

Call options that are very unlikely to end up in the money (a call option is in the money when the market price of the underlying stock is greater than the strike price) are worth very little while call options that are highly likely to end up in the money are worth a lot. Below is a 2 by 2 matrix that summarizes this. Unfortunately, there is no magic formula for where to set your strike and over what duration to write the option over. Rather, you need to decide for yourself where to strike the balance between the amount of premium you receive and the likelihood of having your stock called away. Keep in mind also (more on this later) that the more premium you receive, the more your portfolio is protected in a market downturn — if markets crash, then the option you sold will go down in value (which is good for you since you are short it) and you can either wait for it to expire worthless or buy it back for cheap (buying it back closes your position). So in this case, because you believe that the call option’s price will decline in the future, you would want to sell one that is worth more and thus, receive more premium.

Wow I didn’t expect to go that far into the mechanics and intricacies of writing call options when I started this post. But it is critical to understand what we are doing, especially the risk, before doing it.

Let’s finally return to our Apple example. Recall that we own 100 shares of Apple stock and that we decided to write a 11/15/2019 call (2 and a half months to expiration) with a $220 strike (5% above the current market price). In return for doing so, we will receive $630 in premium. Let’s see how our total position (our Apple stock plus our sold call option) looks on a payoff diagram:

This chart is a bit more complicated than the others so let’s take it one step at a time:

• First, notice how the blue payoff line starts off looking just like it would if you were merely long the Apple stock (if you are long the stock, you own the stock). That means that when the market price is below the strike price on the call we sold, the profit or loss on our position moves in line with Apple’s price (when Apple goes up we make money, and when it goes down we lose money).
• At the strike price of the call we sold, our profit caps out (the blue payoff line flattens out and goes horizontal). At market prices beyond the strike price, the person we sold the call to will pay us the strike price for our 100 Apple shares. That means that no matter how high the price of Apple goes, we can only ever receive the strike price for our shares as long as the call we wrote remains unexpired. This is not the end of the world though — recall that we set our strike price roughly 5% above the current market price. This means that even if have our shares called away from us, by then we will have earned another 5% on our shares, plus the $630 premium we received for selling the call option (an additional 3%). That’s a total return of 8%. On top of that, because we own the shares, we also receive any dividends paid.
• I saved the best part for last. Remember we are entering this position to reduce our risk. The risk reduction derives from the $630 premium that we got for writing the option. No matter what happens, as long as we stay in the position to expiry, then we get to keep that $630. This means that if the market crashes or if Apple reports terrible earnings and tanks, our losses are lessened by that $630 already in our pocket. That’s why on our payoff diagram, the breakeven price of our position has decreased to be below our original purchase price (on the X axis).
• And if the market price of Apple remains unchanged, that’s fine too. We neither make nor lose money on the shares but we get to keep the $630 premium plus any dividends. And then we can sell another call option a few months out and get another $600 to $700 in premium. Cool!

Sorry for the long post but options are complicated and risky, and I wanted to make sure to cover all the basics before recommending a strategy. Finally, I should emphasize that covered calls are not for everyone. If you are the following type of investor, they might be for you:

• Worried about the valuation of your stock or the overall market.
• Somewhat risk averse.
• Desire some cash income but do not want to sell your stock.

Happy investing and cheers!

More by me on Finance, Investing, and Money:

Visualizing the Stock Market with Tableau

The Dangers of Shorting Volatility

A Data Science Project I Did on Investing in Lending Club Loans

On Stock Market Downturns

Do Stocks Provide a Positive Expected Return?

Do You Have Enough Money to Retire?