Covered Calls : Extra Income, Yes*

Zero tolerance takes on a whole new meaning 

The last time the US Federal Reserve raised rates was in Jun 2006. Some central banks around the world have even cut interest rates to negative. Not surprisingly bond yields have plummeted to record lows. Throw in the financial crisis of 2008 and the unprecedented destruction of wealth it brought about and you are looking at a picture tinged with pathos. Clearly, the last few years haven't been kind to savers, especially those in the developed world. And the bad news is - interest rates might not go up in a hurry, as less-than-moderate inflation (and signs of deflation is some economic blocs) lessens the likelihood of a rapid liftoff in interest rates in developed world markets.

The hunt, therefore, for that extra bit of income has never been as intense as it is now.

One (albeit non-traditional) strategy that investors may want to consider to generate that much needed additional income is Covered Calls.

Into the world of Covered Calls

A covered call is a financial market transaction in which you could turn into an option seller (alternatively, called an option writer) by writing a call option on stocks that you already own in your portfolio. The value of that specific option you have written is derived from various factors, like the volatility of the underlying stock for instance. This value, simply put, is the income that you, as the option writer, will earn from that transaction. This income is guaranteed. Yes, you read that right - This. Income. Is. Guaranteed. Now this is exactly where a Covered Call strategy can go awry. Very often the positioning of this strategy makes it look very innocuous (I have often heard asset managers loosely refer to this strategy as 'Renting out your stocks') and well, despite the risk-free premiums  you pocket, this strategy, as we will soon see, isn't free from risks. 

But first, lets look at this from the perspective of the option buyer as well. The buyer of a call option is always expectant of a rise in the price of the underlying stock at expiry (in this instance, let us assume that the option is European style) and if, on expiry, the stock does close above the strike price then the option buyer will exercise his right to buy the stock at the agreed strike price.

Now onto an example to understand this better, let us assume that you have a 1000 shares of Google at a average cost of $400. The current market price of the stock is $761.98 and you most definitely are looking at a sizable mark-to-market profit on your position. You should be one happy investor, right? Not really, instead you are in a quandary. Why? Three reasons (and these are true for Google and pretty much any other stock):

1. You will need to sell out your stock position to realize your capital gains. This might mean reducing your ownership in that very stock that you consider to be a powerhouse of sustained growth, to zilch.
2. You own the stock and you continue to believe in it's growth story but you are finding it difficult to monetize your ownership and generate income (since the company continues to retain earnings and invest in newer profitable avenues for growth). You are also reluctant to manufacture dividends by selling units of your ownership whenever the need for income arises.
3. And lastly, if you bought a stock after it has suspended dividend, how are you best placed to monetize your investment between the purchase date and the expected date of dividend reinstatement? 

It is in situations like these that you might want to consider a Covered Call strategy.

Recall the example I quoted earlier; You hold 1000 shares of Google @ $400 and the current market price of Google is $761.98 and your thought cloud right now contains the first two of the three reasons I mentioned earlier. You think that you would like to earn an income from your Google position and decide to write a call option on exactly 1000 shares of Google at a strike price of $ 775 expiring in a month from now. Lets assume you earn a grand premium of $ 300 for writing this option :-) We now cut to the day when the option expires.

Situation 1

If the Google scrip closes below $775 then good for you, break open that crate of beer and party all night. You made a profit of $ 300 and, more importantly, still own 1000 shares of Google at an average cost $400!

Situation 2

However, if the Google scrip closes at $777, then you are forced to sell your entire holding of 1000 Google scrips to the option buyer at $775 despite the market pricing the very same scrip at $777. You have still made a tidy profit though :  {(775-400)*1000} + $ 300.

Hang on, you might say, I have profited in both these situations then what exactly is the risk in a Covered Call strategy?

And therein lies the case of a potentially large opportunity loss ..

Look closely and you will realize that there is indeed a loss in the second situation. You were forced to sell your Google position for $ 2/share lesser than its market price. An opportunity loss of $2000! Most explanatory articles on a Covered Call strategy cite examples similar to the Google-one that I have used . And that is precisely where this strategy conceals its tail-risks. Most examples, including the one that I  quoted, simulate a very mild Situation 2. Very often gains on the long position are stated to reduce the disappointment of an opportunity lost to sell at the market price (which in these examples are usually only slightly higher than the strike price used).

You would look at a Covered Calls strategy with more suspicion if I had replaced the $777 market price at option expiry in my Google example with, for instance, $901. Your opportunity loss just for that one day (when the option you wrote expired) would be a whopping 15.95%!

Come now, I hear you say, is that even a fair assumption to make? Isn't it ridiculous to assume a 16% single day uptick in an index heavyweight like Google? 

Ridiculous? Possibly. But it did happen ......

On Jul 17, 2015, Google, in just one day, added a record $65 billion to its market capitalization (Google Adds a Record $60 Billion to Its Stock in One Day). What Google added to its market capitalization in just one single day was more than the size of Hewlett-Packard! On that day, after being locked in a narrow range for a while, Google shares rose a phenomenal 16% to a (then) record $699.62. As call option buyers cashed in their chips, one can only imagine the massive flight of assets from Pension Funds and Asset Managers, particularly those overseeing equity funds focused on Technology. A tail-risk had just ripped through the world of Covered Calls and the stocks you thought you had 'rented' out for a while had found a new owner.