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Covered Call: An Options Strategy for Value Investors

Andrew is a self-educated business owner and entrepreneur with plenty of free advice (which is worth exactly what you pay for it!).

Options strategy

Options strategy

Value and Options: Two Categories of Investors

As an investor, I can see that investors seem to fall into two neat categories. Type one is the patient, steady type who does a ton of research before buying a stock based on the underlying fundamentals of the business.

This type always thinks about stocks as a scientist thinks about a field of study, and they believe that intrinsic value matters in the long term. Type one is boring, but their strategy generally works over the long term. The short term is another matter.

Type two is much more interested in following and anticipating trends, will often try to make money quickly, and will frequently put capital at risk in order to get a higher return. Not all type two investors use options, but many do, and options are frequently associated with gambling, with gamification and other gimmicks enticing investors ever further out onto the risk curve.

In a nutshell, the idea of trading options, where losses can be unlimited in some cases, fits far better into the type two narrative than it does for type one, the value investor. And yet, here I am to tell you about an options strategy that may resonate with a type one investor.

The Covered Call

The specific type of option we're focusing on is the covered call. In order to trade options at all, you may need to apply with your broker, and each broker is a little different in terms of how tough they'll make this process. Brokers who want you to encourage frequent trading are bound to have a quick and easy process for adding options, but more conservative services may take a few days and require a few documents to be filled out to apply. You don't need to apply for all types of options, and the brokers out there make this process easier to understand by assigning levels to the basket of actions you can take.

The higher the level, the more risky or complex (or both) the strategies and actions you can use are, and the higher your level of understanding needs to be. Slow and steady wins the options race too, and it's far better to practice slowly and avoid losing money whenever possible, following rule number one: don't lose money.

The second thing to understand is that you'll need to own 100 shares of each stock you want to use the covered call strategy for, and you'll need to keep at least 100 shares for each call you've written (more on what that means in a bit). If you're not already filthy rich, you might not be able to write calls for most of what you own, but if you have lower-priced shares, the odds are a lot higher that you'll meet this requirement.

Having Your Cake and Eating It, Too

Okay, you've set up level one options trading with your broker, and you own 100 shares of a stock. The next thing to do, as a value investor, is to ask yourself: at what price would I sell?

If you're using a catalyst-based value investing strategy, the hope is that the stock will jump up into the range you desire. If you bought earlier this year, and the stock is up 40% without much change in the underlying business, for example, that might be a great time to take some profits. But what if the catalyst never comes to fruition, or if you just own 100 shares of something and want to put it to work?

The solution: sell a covered call and get paid to wait. Here's the key to this whole thing working: you need to be at peace with selling at your strike price. This way, if your stock jumps up above the strike price, your shares will be sold (the 100 that you covered initially), and you should be happy taking profits on a good value investment that just came to maturity, offering you a nice return on your initial investment.

However, you need not be disappointed if your stock doesn't perform a quick fish jump. Instead, you can simply write another covered call and sell that as soon as the last one you wrote expires. This is great for you if you're an income investor, especially if the stock also offers a consistent dividend payment.

Financial Independence

If you seek financial freedom and would like to live off of the cash your portfolio throws off, but you don't want to touch the "honey pot" (the initial investment that produces the cash for you), a combination of dividends and covered call options can fit the bill nicely.

A high-yielding dividend portfolio might throw 4–5% your way each year, and that might be enough for you to pay your expenses. If it's not, adding covered calls has the potential to add another 1–3 percentage points, giving you a bill-paying margin of safety.

This is a relatively low-risk strategy, but you do need to have a healthy respect for how powerful options can be, especially considering if you sell your stocks before your option expires. Then the strike price is surpassed, and you'll have no choice but to purchase another 100 shares now, well above where you wanted to sell them in the first place. Having a checklist in place can help to keep this risk in check.

This content is accurate and true to the best of the author’s knowledge and is not meant to substitute for formal and individualized advice from a qualified professional.

© 2021 Andrew Smith