How To Find Best Stocks for Covered Calls?
Beta is a risk indicator widely used to compare stock volatility. It helps us find stocks for covered calls. We search for stocks with a low to slightly above average beta, which means they don’t move as much as growth stocks. This technique is enhanced by dividend-paying stocks.
Covered calls increase income and provide downside protection. There is, of course, a cost to this. Selling call options against a stock limits profit potential if the stock rises substantially. If you sell a covered call at $20, you lose any profit if the stock closes above $20. This may be the covered call strategy’s biggest flaw.
Citizens Financial Group (CFG) Covered Calls
Let’s go over the labels in the screenshot below.
Equity: Buying 100 shares of Citizens Financial Group (CFG) at $52.33
Expiration: March 18th 2022.
This shows the covered call was for Citizens Financial Group (CFG) and it expires on March 18th, 2022, with a strike price of $55.
Net Credit: Each contract covers 100 shares with a premium $65 per contract.
Max Loss: This is assuming the stock drops to $0 per share. The stock is currently $52.33. The $55 March 18th call premium is $0.65. So, $51.68/share is the breakeven point. In the worst-case scenario, an investor loses $5,168 on 100 shares if the stock falls to $0.
Calculate the Profit from Covered Calls
Max Profit: This assumes the stock closes at or above $55 per share on March 18th. The current share price is $52.33. The $55 March 18th call premium is $0.65. Thus, the maximum profit per share is $3.32. The formula is as follows:
Current stock price: $52.33
Premium for the $55 Strike Price March 18th Call: $0.65
Total Proceeds including Call Option Premium When Sold: $55.65 ($55.00 + $0.65)
Maximum Profit: $3.32 (Total Proceeds – Stock Purchase Price) ($55.65 – $52.33)
Outcomes of Covered Calls
Citizens Financial Group (CFG) Remains Flat or below $55
The 65-cent premium represents a 1.24% return on the $52.33 underlying share price. ($0.65 ÷ $52.33 = 1.24%). Also, the current quarterly dividend per share of Citizens Financial Group (CFG) is 39 cents. Our compensation from Citizens Financial Group increases as the seller of this call (CFG).
Citizens Financial Group (CFG) goes above $55
In this case, the covered call writer must forfeit the shares. Given that the contract was sold at $55, the total return is $3.32 per share, or 6.34 percent. ($55 + $0.65 – $52.33 = $3.32). ($3.32 ÷ $52.33 = 6.34%).
The Drawbacks of Covered Calls
What if CFG takes off? The only disadvantage of writing covered calls is that you have to sell your shares at the agreed strike price, but the stock has risen above it. Even if Citizens Financial Group (CFG) is at $60, you’d still sell at $55. But this is like selling a stock and then watching it rise.
Why is Citizens Financial Group (CFG) ideal for this strategy?
Citizens Financial Group (CFG) has a beta of 1.5, which means it moves less than a growth stock. This is exactly what a covered call writer wants because they want to increase their income from the underlying position rather than sell it. As shown in the chart below, Citizens Financial Group (CFG) has a narrow trading range between $40.00 and $57.00.
Citizens Financial Group (CFG) pays a good dividend, so this strategy generates extra income without selling the stock.
Who Should Consider Covered Calls?
Covered calls are ideal for portfolios with several hundred shares in one or more stocks. Even better if they pay dividends. The covered call strategy is popular with retirees and income seekers because it has no downside to current capital compared to a buy and hold strategy.
Avoid These Pitfalls
We avoid open option positions in earnings due to the higher volatility. A good earnings report can significantly boost any stock, forcing you to sell before it expires. A poor earnings report can also sink a stock, making it difficult to recover.
Time is crucial. Rather than writing a single long-dated option, we tend to write several short-dated options. The longer the time horizon, the slower the decay of option premiums.
This article explained the basics of covered calls and the ideal companies for covered call strategies, which are steady and slow-moving stocks that pay a dividend.