Write covered calls in long-term holdings without being called

Writing covered calls has long been a popular way for short-term traders to generate steady streams of income in their brokerage account. If you buy 100 option shares trading at $28 per share, you could write a call with a strike price of $30 and an expiration date a month from now. In exchange for giving someone else the right to buy your shares for $30/share (which would represent $2/share in capital appreciation), you also receive a bonus in the form of cash.

If you are a committed covered call writer, having your shares taken away from you and being forced to sell them at the agreed-upon strike price is actually a good thing. It represents a successful trade: the premium you collected is yours, and you also most likely secured a modest increase in capital gains.

But what if you are a long-term investor? What if you don’t want to sell your shares? Generating additional income is all very well, but if that income comes at the expense of your long-term goals, it may not be worth the risk.

Still, there is a lot of potential premium income spilling out into the options market, and it would be a shame not to collect some of it for yourself. So the real question is, “Can long-term investors benefit from writing covered calls without having to worry about being forced to sell their long-term positions?”

The Solution: The 1/3 Covered Call Writing Strategy

I am a long term investor myself and have faced this dilemma first hand. Covered call income is wonderful, but the upside risk when the underlying stock makes a big move up tends to undermine the entire premise of long-term investing.

The solution I use is what I call the 1/3 covered call write strategy. The gist of the strategy is this: I only write covered calls on about a third of my stock.

This still allows me to generate additional income on my holdings, but by making call options on only a small portion of those holdings, I greatly reduce the chances that I will ever have to sell a stock against my will.

A quick example:

Let’s say I own 300 shares of XYZ stock trading at $27/share. I write three covered calls at the $30 strike price and collect $1 in premium per contract (ie $300 cash). Suppose now that the company announces impressive earnings numbers and the stock jumps to $37 per share.

I still made money, but unfortunately, the options are most likely too deep for me to implement for additional income (or implement and even a higher strike price and recoup more capital gains). In short, I’ve locked in profits of about $1,200 ($900 in capital gains as 300 shares rise from $27/share to $30/share plus $300 in premiums from the three calls I’ve written). Not bad, but from a strictly buy and hold angle, if I hadn’t written the calls in the first place, I’d be up over $3,000 (300 shares rising from $27/share to $37/share).

And how does The 1/3 Covered Call Writing Strategy fare? If I had written just one covered call, my total earnings would double: $2,400 (200 shares rising from $27/share to $37/share = $2,000 + 100 shares rising from $27/share to $30/share = $ 300 + $100 in premium income).

But wait. The game is not over yet. Even though the only covered call option I wrote now is seriously in the money, I still have another 200 stocks waiting in the wings. By not writing calls to them, I now have the ability to use them to “bail out” my first 100 actions.

If the stock is trading at $37/share as expiration approaches, it will cost me approximately $700 to buy back the $30 call I initially wrote for $100. I go ahead and buy back the original call for $700 and then write three new covered calls within a couple of months at the highest strike price of $40 for $2.50 in premium (or $750 cash).

So what have I achieved? My net premium income from all transactions to date is $150 ($100-$700+$750) and I have also put myself in a position to participate in gains of up to $40 per share if the stock continues to rise. And if it’s not that way? All three call options will expire worthless and I can start writing my next 1/3 covered call. And I also have $150 in net premiums when it all settles down.

Conclusion:

The example above is just that. Individual results will vary widely as the premium is based on the implied volatility of each individual stock. Strike prices are also important: the further away from the money, the more upside protection you give yourself. And, needless to say, you’re not required to write calls on exactly a third of your holdings. Whether you write covered calls on a higher or lower percentage of your portfolio should depend on your personal preferences and the specific terms of the stock you own.

But the concept behind the 1/3 covered call drafting strategy is sound. Although there is no guarantee that you will never be taken out of your positions, the strategy gives you greater flexibility and much more protection on the upside.

Food to go? The ability to generate an additional 3%, 5%, or even 10% a year in long-term holdings will have profound compounding consequences.