Technology stocks have appreciated significantly the last few months. Sector performance has slowed as many investors sell their holdings and rotate into demand sensitive sectors.
Energy stocks, for instance, are up close to 20% during the last 3 months.
Not all investors are reducing appreciated positions. Some like the stocks they already hold, even if they expect little near-term appreciation.
Others are deterred by the potential tax consequences of selling appreciated positions close to year end.
An alternative is selling is to instead sell covered calls. The strategy consists of selling call options against your existing stock holdings.
Call options give the option holder the right to buy stocks at a specific price (the “strike”). The option seller receives an upfront premium for selling the option.
The optional right to purchase ceases at a set date, and the contract expires worthless if it is not exercised.
The option is usually exercised when the stock price exceeds the strike at expiration. If the option is exercised, the covered call seller delivers the stocks and receives the strike price.
Why use covered calls
The benefits of the strategy originate from the premium received by the option seller. The cash received by the stockholder reduces the cost basis of owning stocks without liquidating existing positions.
Altogether, covered calls are less volatile than underlying stocks. Stock price movements are partially counterbalanced by premium value changes. If the stock drops in price, the premium of the option also falls.
The strategy is appealing when the underlying stock is volatile. The more volatile the stock, the more premium the option seller receives.
Drawbacks of the strategy are a capped upside and unprotected downside below the strike. It makes most sense when strong short-term appreciation is unlikely.
As an example, Amazon (AMZN) stock is up close to 60% this year. Yet the stock has been trading sideways for some months.
A three-month call with a strike 5% above the current price (“out of the money”) can be sold for a 5% premium. The above-market strike allows for some appreciation, and the stock own pockets income from the premium.
Choosing a strike close to the market price (“at the money”) maximizes the net option premium, generating more income than selling an out of the money option. A six-month option struck at current market prices for Apple (AAPL) has a 10% premium.
The premium generated can substantially reduce the net value of holdings when a low strike is used, freeing up cash without closing the position.
Tesla (TSLA) shares have increased in price more than sixfold this year. Investors wishing to reduce their position without selling the stock can sell a long-term call with a low strike.
A call option struck 30% below the current market price (in the money) has almost 45% of premium. The strategy capitalizes on the high volatility and option premiums of the stock.
Once executed the position has 15% of upside for the next year and monetizes almost half of the current value of the stock.
Disclosure: I hold Amazon (AMZN).