Benefits of Covered Call Writing
Covered calls writing generates returns in three ways:
- The call writer collects the premium up front.
- The covered call writer earns any dividends paid on the call-covered stock.
- The call writer may realize the gain when the underlying stock price goes up.
For example, AT&T is trading at $35. The strike price of $37 calls, 9 months out to expiration, is trading at $1.00. The stock is paying a dividend of $0.40 per quarter.
In this example, we are writing a call that will expire 9 months later, so we’ll collect $1.20 ($0.40 x 3) per share worth of dividend. The cost of a covered call position will cost $34.00 ($35.00 – $1.00).
9 months later, if the stock trades at or above the strike price at expiration, the position will generate profits of $1.00 in the covered call sale, $1.20 in dividends, and $2.00 ($37.00 – $35.00) in price appreciation. That is a total of $4.20 on a net investment at the cost of $34.00 for just 9 months. The ROI turns out to be 12.35%.
Covered Call Repair
What happens if AT&T goes down? Using the same example from above:
- Bought at $35.
- Wrote a call at $1. The call expires in 9 months.
- 9-month worth of dividend is $1.20.
The purpose of the dividend-paying stock covered call writers is to earn steady income by collecting the premium and earning dividends with controlled risks.
Another benefit of writing covered calls on dividend stocks is the ability to collect the dividend. Ideally, the dividends will support the stock price even when the overall market is bearish. This will help us reduce the risks.
Finally, in a directionless market, the strategy should generally outperform the market averages, as the proceeds from option writing would add to the returns on the long stock positions without leaving much money on the table from those few stocks that did well in a market moving sideways.