What Is the Covered Call Investing Strategy?
What if the market is moving neither up nor down, but sideways? What if you need cash flow? Then perhaps the covered call strategy is called for.
I recently bought shares of SLVO, which is an exchange traded note that uses the covered call strategy to generate income. It was an amusing experiment with only a token amount of shares, and in the process I learned more about the covered call method of investing – which I'd like to share with you today.
SLVO is an interesting ETN, and the explanation on Credit Suisse's own site says this:
The strategy is designed to generate monthly cash flow in exchange for giving up any gains beyond the strike price. The strategy provides no protection from losses resulting from a decline in the value of the SLV shares beyond the notional call premium received, if any.
– Credit Suisse
In short, you limit your potential gains to receive cash flow. Yet you do nothing to protect against losses. So how do they do that?
Let's start by defining what call options are, which is half of where "covered call" gets its name from. Call options give someone else the right to buy a stock at a given price. However, the other party has no obligation to actually buy the stock; they only exercise the option if the price is in their favour.
There are three components to call options: the strike price, the premium, and the expiration/time to maturity. The strike price is the specific price the option will allow someone to buy a stock at, the premium is a fee always given to the seller for the option, and the expiration is how long the call will last for.
If you're curious, the "covered" in "covered call" comes from buying the underlying shares that you're giving the option to buy. That way you already own the stocks in case the second party exercises their right to buy.
Let's look into a fictional example. Say you purchase a share of SLV (a silver ETF) at $50. You then immediately sell a call option to someone for a premium of $3 with a strike price of $55. Then time passes and you either make your gains, or you suffer your losses.
Let's say the share price increases beyond the strike price, e.g. to $60, by the time of maturity. Because the share price is higher than the strike price, the second party will exercise their right to purchase a share at $55. This means that they gain $60 - $55 = $5 in capital gains, minus the $3 premium. On the covered call seller's end, they gain $55 - $50 = $5, plus the $3 premium.
The covered call seller received their maximum profit, which was the premium plus the difference in purchase price and strike price. Any further gains would simply go to the second party who bought the option.
However, what if the stock price didn't go up that far? If instead the price had stayed the same $50 (or barely moved up to <= $55) then the second party would not exercise their option. They would suffer a loss of $3 for the premium, whereas the covered call seller would gain any capital gains plus the premium.
Then, what if the stock price fell? Well in that case, both parties lose out. Though if the stock falls, the covered call seller is at least offset by the premium. If the price fell to e.g. $47 per share, then the $3 premium would exactly counteract the $3 capital loss. Any further fall would result in lost money for the covered call seller.
If you check the Investopedia page for the covered call strategy, you'll see the graphs that showcase a substantial potential for loss and a hard-capped limit for profit.
So what's the point of unlimited loss potential with a hard-capped profit potential? Well as alluded to earlier, this method works great in markets where the price is stuck within a narrow band. In other words, a sideways market that neither grows nor falls.
Small fluctuations in price are fine when you have a covered call, and the premium allows you to generate income without appreciation of the asset (the stock price going up.) This premium also is great if you need cash flow, which is how I first discovered SLVO. It had a ridiculously high dividend yield thanks to its low price and income-generating strategy, and most interestingly it paid out monthly dividends instead of quarterly.
One more noteworthy thing about SLVO: its price has been decaying since inception. Likely because it's an ETN with a maturity in 2033, though I don't fully understand why. My intuition is that the price reflects the potential value of all those dividends, and as the ETN nears its maturity date there's less months worth of dividends to add up. If that is the case, I'd expect to see the ETN price fall near to $0 at the time of maturity (or reverse stock splits to occur).
Although some ETNs are like bonds, SLVO is a different kind of instrument entirely thanks to its covered-call strategy. It's a fascinating thing to look into, and I hope you enjoyed this foray into higher level finance.
For more grounded personal finance advice, I might suggest these tips for kinksters: