Due to ongoing market conditions and Fed policy, investors are facing persistently low interest rates. It’s an unfortunate side-effect of necessary monetary policy given the state of the economy and the ongoing pandemic. Because of this monetary policy, it’s still a challenge for savers to create yield. That said, there is an alternative way to create yield against your stock holdings: sell covered calls.
A Covered Call is an options trading strategy in which the trader holds a long position in a stock and sells a call option on the same stock in an attempt to generate income. This is a VERY conservative strategy. For example, if I owned 100 shares of Snap (SNAP) I could sell one call against my 100 shares. And when I sell that call I collect a premium (essentially collecting an insurance premium).
How to Sell Covered Calls
Below is an excerpt from a Bloomberg article about selling covered calls using Goldman Sachs research.
“Interest in an options strategy that involves selling bullish calls while holding the underlying stock to generate income has increased substantially over the past six months as slowing economic growth shakes investors’ faith in U.S. equities, according to Goldman Sachs.
“Overwriting, as the strategy is called, has historically outperformed the buy-and-hold approach when stocks trade within narrow price ranges or decline, according to Goldman derivatives strategists including Vishal Vivek. Their research found that selling one-month, 10% out-of-the-money covered calls on S&P 500 Index stocks has led to an annual outperformance of 1.4% on average over the last 16 years
“Of course, overwriting is not without its own risks. While the call options are covered by the underlying stock ownership, a rally through the strike price could translate into a sale as shares are called away, forfeiting further gains on the position.”
Create Yield with Snap (SNAP) Covered Calls
Let’s consider a hypothetical covered call strategy to create yield with the aforementioned SNAP shares. At the time of publication, a 10% out-of-the-money call expiring next month is commanding a 6.8% premium. A premium that big prices in a lot of volatility, which indicates the market expects bigger price movement, making it more likely that your shares would be called away.
But how do I determine which strike should I sell against my SNAP stock position?
There isn’t a surefire answer for each situation. But I will show you my general thought process.
These are the questions I ask myself (in this order) for choosing a strike price to sell:
- At what price am I willing to sell the stock? If I am willing to sell SNAP at 60, then I would sell the 60 strike. If I am willing to sell the stock at 65, then I would sell the 65 strike.
- If the market is stable, and trending higher, then I am more likely to sell a call further away from the current stock price. Perhaps I’d go with the February 65 strike for SNAP, which would net me a premium of $2.45. However, if the market is weak, I might sell a call at the 60 strike for $3.75, as this sale would net me a much bigger premium/insurance policy.
- Is this a trade that you hope will make a small premium quickly? If so, sell a short-term option as it will lose its value very fast, such as the February call. If it’s a long-term stock position that you want to hold onto for a while, then sell further out in time and further out-of-the-money.
At the end of the day I think the #1 criteria above is most important. If you set a price target, and sell at that strike, then you have made a choice that you can live with. And you will have picked up a nice yield in the meantime.