A while back, I posted about covered call options. I mainly invest in stocks, bonds and mutual funds, but I use a small portion of my equity allocation to invest in covered call options. Covered calls can provide immediate income, but at the risk of long-term gains.
Risk of Long-Term Gains
We’ll go through some examples in a bit, but the risk of long-term gains comment is important. As we know, over the past 100 years, the S&P 500 (an index consisting of the 500 largest US public companies) has grown an average of 10% per year with dividends re-invested. While this does not guarantee us a 10% annual return, if we hold an S&P 500 index for 10 years, we’re pretty likely to earn 10% a year. If we hold it for 20 years, it becomes even more likely. If we hold it for a year, we’re almost as likely to lose money as gain.
Over periods of 5, 10, 20 years and longer, the S&P 500 has been a huge wealth creator.
Quick Refresh on Covered Call Options
For those who haven’t read the other post, call options are contracts that give the buyer the option, but not the obligation, to buy shares of a security at a specified price, on or before a given date. Call options can either be covered or naked. While naked sounds fun, it’s really a bit scary.
Covered call options are options in which the seller holds the shares of the security that are covered by the option contract. We’ll go through an example in a minute. For a naked call, the seller of the contract does not hold shares and will have to buy shares on the open market if the option buyer exercises the option.
Covered Call Example
I’m going to go through one of my recent examples. I’m a big fan of Crowdstrike Holdings (Ticker: CRWD). I hear the internet is pretty popular and I expect more and more nefarious characters will be using this new tool to bilk unsuspecting individuals and companies of large sums of money. I expect cybersecurity will be an important field and will be around for quite some time. Crowdstrike is a leader in the field, and despite some recent problems with a software release that brought the online world to its knees for a short period of time, I continue to be bullish on the company.
After the “incident”. CRWD stock pulled back and it was getting close to my target buy price. Rather than buy more, I decided to look at Options on CRWD.
On 8/19/24, I bought 100 shares of CRWD at a price of $269.44 per share. This cost me $26,944. I immediately sold a call option on these 100 shares. The call option was trading symbol -CRWD240830C270. Let’s break this down.
- Option symbols always begin with a “-“
- CRWD refers to the underlying security on which the option is based – Crowdstrike, in this case.
- 240830 is the expiration date. On August 30, 2024, this option expires.
- 270 is the strike price. If the price of Crowdstrike is 270 or more on Aug 30, the option will be exercised and I will sell the shares at $270 per share, and deliver them to the option buyer. If the price is below $270, the option expires and becomes worthless.
Selling an Option Contract
I left out an important piece. I sold -CRWD240830C270 on 8/19/2024 for $14.90. Option prices reflect the price per share. Option contracts cover round-lots of 100 shares, so $14.90 per share nets me $1,490.00 for 100 shares. Sweet! That’s a 5.53% return on the $26,944.00 I invested to buy the shares.
I patiently waited the 11 days between 8/19 when I sold and 8/30 when the option expired. CRWD went up in price and closed at $277.28 per share on 8/30/24.
Exercising an Option
Our broker does all the work here. On Saturday morning 8/31, I see:
This will settle on 9/3, but I’ll see the $26,999.24 (broker takes a 76 cent fee) in my cash balance and the shares will no longer be in my account.
Had CRWD closed below the strike price of 270, I would have seen a notification on my transaction activity, but the option would disappear from my holdings and the shares would remain.
Financial Impacts
On this particular transaction, I made the $1,490.00 in premium. This is ours to keep regardless of whether the option is exercised or not. I also made (26,999.24 – 26,944.00 = $55.24) a capital gain of $55.24, so my total income was $1,545.24.
On a $26,994 investment, I made $1,545 in 2 weeks. That’s a 5.7% return. Annualized that’s more than 130%.
Why Not Do More of This?
I mentioned in my other post that I only allocate a small portion of my equity holdings to covered calls. Here’s why:
- Crowdstrike was an anomaly of sorts. I took advantage of the fact that the stock had pulled back significantly and was trading at a high premium.
- Premiums are typically around 1-3% per month, not 5.5% for 2 weeks.
- Options come with more risk than equity ownership
Risks
While we can get giddy about the quick $1,500, we need to be aware of the risks involved with trading options. Covered calls are much more conservative than naked calls, but there is still risk.
Stock Price Risk
My story had a happy ending. The stock closed above the strike price on expiration. I sold the shares and took a small capital gain.
What would have happened if the stock price dropped?
Small pull-back
If CRWD closed at $265 on the strike date, I could have either sold my shares at a loss or I could have tried to sell another call option.
If I sold at a loss, I paid $26,994. I could sell for $26,500, so my loss would be $494. I got $1,490 in premium so I net about $1,000 gain in total – still not bad.
Big pull-back
If CRWD continued to slide – which it very well could have because the outage is still fresh in everyone’s mind and Delta and other companies are threatening litigation to recoup costs, so Crowdstrike could have some big debts in its future which could cause a bigger slide. Let’s say it dropped 30% to $189 per share.
At $189 per share, I would be unlikely to sell as my loss would be ($26,994 – $18,900 = $8,094). $8,094 loss. Even considering my $1,490 in premium, I’m out over $6,000.
And if I wanted to hold the shares and resell the option, my alternatives aren’t great. No one will buy an option at a strike price of $270 when the stock price is $189. Would you? Would you pay money to buy shares in the future at $270 when the stock price today is $189. Not bloody likely.
So my other alternatives is to try and get a few hundred dollars to sell at a strike price of $195 or so. While this gives me a few dollars in my pocket today, at strike, I still have a ($26,994 – $19,500 = $7,494). $7,494 loss.
Penalty Box
My best alternative and the one I use with covered call option stocks is to send them to the penalty box.
Basically, I sit and wait for a recovery. Rule #1 for me is that I only buy stocks for covered calls that I would be happy to buy and hold for the long-term at this price.
And for me, anything in the penalty box is counted against my budget for covered calls. If my budget that I set is $30,000 in covered call stocks at any one time, and I have $26,944 – cost, not value) tied up in CRWD in the penalty box, I only have $3,000 ish to use for covered calls, until CRWD recovers.
Risk: Loss of Capital Appreciation
This is the biggee for me. I have 133 shares of CRWD that I intend to hold forever. I do not sell call options against these shares. I have bought them at various times over the past 4 years. My cost basis is $14,434. The current market value of these shares is $36,682. That’s a gain of ($36,682 – $14,434 = $22,248) or 154%.
And the best part is, I’ve done nothing. I researched the company, bought shares, continued to add on pull-backs, and my investment has increased 154% in 4 years. That’s 38% per year.
I’d need an awful lot of covered calls to beat this.
Taxes
I do want to make a quick note on taxes. I do all my covered call trading in my IRA. While it sounds crazy to take risks with retirement money, this is a scheme (I love the word scheme – sounds devious) to avoid taxes. IRA money is taxed as ordinary income when it is withdrawn. There are no taxes on income or capital gains in the current year.
If I were trading in my taxable brokerage account, I would pay taxes this year on the capital gain – which would be short-term capital gains, which is taxed at a much higher rate. And I would pay taxes on the premium I received. This takes a huge bite out of any gains, and makes a covered call option strategy a lot less viable.
Wrap-Up
I like covered calls. I view them as a way to leverage the work I’m already doing to research companies and make a little income with fairly low risk. For every CRWD, there is an AMZN or TSLA that ended up spending quite a bit of time in the penalty box and testing my conviction.
Stock prices fluctuate wildly. Sometimes they make sense, sometimes they don’t. As long-term investors with conviction, it’s easier to ride this out than as an option trader who is more focused on making a quick buck. Which is why I limit my exposure to options, and I only buy companies I’m happy to hold at the purchase price in case they have an extended stay in the penalty box.
Read here for an example about Caterpillar.
I didn’t talk about naked calls on purpose. I wouldn’t touch them with a 10 foot pole. In a naked call, I sell the option, but I don’t hold the shares. This means if the stock hits the strike price, I have to buy shares on the open market to deliver them to the option buyer. Since the potential for the stock price to go up is theoretically unlimited, the loss could be unlimited. I can’t afford an unlimited loss.
Anyway, covered calls can be a good source of income, but the short term enticement of quick cash can distract us from our long-term goal of letting compounding work its magic to build our wealth.