This post discusses how to select stocks that are suitable for covered calls. In addition to protecting against losses, this technique boosts income. When combined with dividend stocks, this strategy can significantly improve the portfolio’s passive income.
- How To Find Best Stocks for Covered Calls?
- Why is Citizens Financial Group (CFG) ideal for this strategy?
- Example of Citizens Financial Group (CFG) Covered Calls
- The Drawbacks of Covered Calls
- Who Should Consider Covered Calls?
- Avoid These Pitfalls
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. Stocks that pay dividends can be especially helpful for this strategy.
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.
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.
Example of 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 Citizens Financial Group (CFG) 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)
Possible Outcomes of Citizens Financial Group (CFG) 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). That is, by adding the 39-cent dividend, the return goes up to 1.99%. (($0.65+$0.39) ÷ $52.33 = 1.99%)
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%). When factoring in the 39-cent dividend, the total return on investment is $3.71, or 7.09 percent. ($3.71 ÷ $52.33 = 7.09%).
The Drawbacks of Covered Calls
What if CFG takes off? The disadvantage of writing covered calls is that you have to sell your shares at the agreed strike price when the share price has risen above it. Even if Citizens Financial Group (CFG) is at $60, you’d still sell at $55.
There is, however, a way to avoid selling the shares. You could roll a covered call. Simply put, you can do this by selling a covered call for the following month while buying back a covered call for the current month. This means that you can keep holding onto the stock while earning passive income from the covered call premium.
Who Should Consider Covered Calls?
Covered calls are ideal for portfolios with several hundred shares in one or more stocks. Moreover, the outcomes are considerably more favorable if the stocks pay dividends. In comparison to a buy-and-hold strategy, the covered call strategy provides some downside protection for the underlying capital, which makes it appealing to retirees and income investors.
Avoid These Pitfalls
We avoid open option positions during earnings season because the market is more volatile. A good earnings report can significantly boost any stock, forcing you to sell before it expires. On the other hand, a stock’s value can drop after a disappointing earnings report, which makes it harder to make a comeback.
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.
The ideal stocks for the covered call strategy are those with a beta that is below or slightly above the average. With a low beta, the stock’s price is less volatile than that of growth stocks. The best stocks to invest in are those of established companies that have a history of generating steadily rising profits. Stocks that pay out dividends can be especially helpful for this strategy.
Using covered calls is a great way to boost your income and protect against some losses. There is, of course, some cost to this. A stock’s potential profit is capped when call options are sold on it. This is potentially the biggest drawback with the covered call technique.