A while back I wrote a post on covered call options so I wanted to provide an update with a real example to demonstrate some of the concepts we discussed.
Today is May 20, 2024. Friday, May 17 was the big monthly option day as well as my 61st birthday. Many companies have option contracts that expire weekly on Friday, some only offer monthly contracts. The monthly ones typically expire on the 3rd Friday of the month. Anyway, May 17, I had a bunch that expired.
Caterpillar
With all the infrastructure spending going on in the US, I got a little excited about Caterpillar back in September of 2023. It’s a cyclical company. I hate that term. It means the companies performance follows a business cycle, however, these business cycles are nearly impossible to predict. But the term makes it sound like the smart investors know when to buy in and to sell out while we rubes are just along for the ride. That’s crap. No one knows.
Anyway, I bought 100 shares of Caterpillar on 9/15/2023 for $278.22 per share, and I sold a 280 Oct 13 call for $6.45.
Quick Review
I sold someone the option, to buy my 100 shares of Caterpillar for $280 per share at any time on or before Oct 13. I was paid $6.45 per share – so $645 for the option. And since the 280 strike price is higher than the $278.22 per share that I paid, I also make a small capital gain if the option is exercised.
Back to Caterpillar
The price danced around a bit between 9/15/23 and 5/17/24 and I sold an Oct 13 call that expired, and then a Dec 1 call that expired. Cool free money.
December was a bit of a pull-back in the Caterpillar stock price – it went down to $234, so I couldn’t sell a Jan 280 call for a worthwhile premium, so I went all the way out to May. I sold a May 17 280 call for $7.54.
May 17
Caterpillar recovered nicely between Dec 2023 and May 2024. The closing price on May 17, was $356.27.
Some smart investor paid $754 back in December for the option to buy Caterpillar in May for $280 per share. Today(5/20) at 10:48, Caterpillar is at $361.43. Let’s say the investor sells those shares that he purchased Friday for $280 (from me, bummer). The per share capital gain is 361.43 – 280 = 81.43. So, for 100 shares, this investor makes a quick $8,143, less the original premium of $754 = $7,389 net gain.
Cool for the investor. He made $7,389 return and he only risked $754. That’s almost a 1,000% return. The investor didn’t put up the cost of the 100 shares. He only bought them if the stock closed above the 280 strike price on May 17 – so he’s taking no risk on the shares.
Cool also for me. While I’m bummed that I had to sell the shares at $280 and missed the run-up to $361, I got:
- $2,191 in option premium for the 3 option sales – 2 of which expired worthlessly as Caterpillar closed below 280 on the expiration date
- $178 in capital gain – I bought 100 shares at 278.22 per share and sold them at 280 per share.
- $260 in dividend income. Caterpillar pays a $5.60 per share dividend. I held the shares for just over half a year so I got 2 quarterly dividend payments.
My total income was $2,629. I put up $28,000 for the shares, so my return was 9.38% for 8 months. Not too shabby.
Long Shares
I mentioned above that I got excited about Caterpillar back in September 2023. I thought it was a good long-term opportunity so I bought 200 shares. I sold call options on 100 of those shares, and kept 100 shares for myself. Those shares are now up 28%. Yay!
Final Thoughts
Selling covered call options can be a good, fairly low-risk way to supplement income. However, there is risk.
The big risk here is tying up a large portion of our capital in covered call options, which generate income, but which also caps our upside. If we cover all of our positions, we’ll never have a stock that doubles once, twice, or many times over. These are the stocks that really make a difference in our wealth.
There is also the risk of our stock going down. Caterpillar was at $234 in December, when my 2nd option expired. If I sold Caterpillar here, I would have lost money on my purchase (at 280) and the option premium from the 2 prior sales would not have covered my loss. I could also have decided to sell a lower strike call option in December, but this would have made my trade a net loser as well.
What happened with Caterpillar is very common, but often the timeline is longer. Sometimes a stock pulls back for a year or more and we sit on the sidelines waiting for the price to recover so that we can sell another call option for a strike price above what we paid originally.
And while the 1,000% return that the other investor received is impressive, this is not typical. It’s hard to be right as a call buyer. It typically requires making lots of bets on lots of stocks to get one big winner. That can be costly. I use the words bet for a reason. Speculating on short term price movements is a gamble.
Finally, I do all my option trading in my IRA because there are no current tax implications. If you decide to trade options in a non-tax-advantaged account, you will pay taxes each year on the option premium and any capital gains. And capital gains will likely be short-term gains, which are taxed at a higher rate.
Good luck.