Most investors know that volatility can inflict pain on even the best holdings. So today we’re continuing a series of posts on using options to hedge.
Owning calls fixes the price at which a security can be purchased. They make money when shares rally, which makes them the opposite of owning puts.
However, traders can also sell calls on companies they own. That allows them to generate income and establish a limited hedge, somewhat resembling puts.
Say you’ve been riding Netflix (NFLX), the S&P 500’s top gainer this year. A client may have entered the stock below $190 in December, and watched as it blasted all the way past $400 in June. He or she is obviously happy about the run but may feel a little anxious about sitting on a gain of more than 100 percent. This is when the covered-call strategy can be very useful.
This screenshot of TradeStation’s mobile app shows the options chain for NFLX. The stock is quoted for $395, while the July 380 calls have a “bid” of $29.75. Imagine the customer sells, or “writes,” those calls. Here’s what happens:
- First, let’s say they own 100 NFLX shares.
- A single option contract controls 100 shares, so they sell 1 contract.
- They sell the July 380 calls for $29.75. Multiply that by 100 shares and they collect $2,975 off the bat.
- Writing the July 380 calls means they’re on the hook to deliver their NFLX shares for $380 if the price remains above that level on expiration later this month.
- But remember they already collected $29.75 per share, so their actual proceeds would be $409.75. That’s $14.75 above the current $395 price. So, they’re taking money out of the market — so called “time value” or “extrinsic value.” (See our next post for more on that.)
There’s also a hedging component because their $410 proceeds are safe as long as NFLX stays above $380 through expiration. In this case, they can endure a drop of xx percent.
Additionally, even if it goes under $380 they have some protection because the calls they sold short will lose value. The extra $15 of time value is essentially their cushion below the strike price. So in this case they can endure a drop to $365 before they really see losses. Here’s the math:
Sell the July 380 calls for $30 when the NFLX is at $395. If the stock falls to $365, the options become worthless. They lose $30 on the shares but make $29.75 on the short calls.
The big difference between this strategy and protective puts is that covered calls only provide limited downside risk. In this case, they can lose money below $365 — all the way down to zero.
Another difference is that potential upside gains are also limited. If NFLX spikes to $500, they’ll still collect no more than $409.75 per share.
So why do it? The main reason is that it’s a way to protect gains on a stock that’s moved higher. It generates income here and now, while buying protective puts costs money. The other benefit is they’ll collect income from a stock drifting in a range.
In conclusion, covered calls are a potentially useful technique for investors looking to protect profits after a big market rally. They offer limited protection, but don’t eliminate all downside risk.