There are a lot of investors selling covered calls on long-term investments and many say that it is a wasted income opportunity if you don’t. There is however a big problem with selling covered calls on stocks that you are highly bullish on, which is important to keep in mind. I also made a post some time ago, asking for input on my suggested solution to this problem, but I do not really feel like I explained my thoughts in enough detail, so I will try to explain my strategy again, this time in more detail.
If you already know the problem with selling covered calls on stocks that you are highly bullish on, then feel free to skip down to my “ALTERNATIVE STRATEGY” below, as I would still very much like your input on this.
THE ISSUE WITH SELLING COVERED CALLS ON STOCKS YOU ARE HIGHLY BULLISH ON.
For this example, I am going to be using TSM. This is a stock that I am highly bullish on, and hence also a stock that I would seriously consider using my alternative strategy on.
Let’s assume that I bought 100 stocks of TSM today at $100/stock, giving me a total investment of $10,000. I am highly bullish on the stock, but still want to create an income flow from the stock position. The “traditional” way is that I sell an OTM covered call on a short-ish expiration. In this example, I am selling a OTM covered call for August 30, 30days from today, with a strike of $112, $12 above the current stock price. The bid/ask midpoint here is about $5.20, so in this example I net $520 from selling the covered call.
If the stock price drops or trades below $112 at expiration, I will keep my stock position, having netted the $520, and I can then sell a new covered call for the next cycle. This is the optimal scenario for this strategy and the aim of anybody selling covered calls on stocks they want to keep.
BUT this is a stock that I am highly bullish on. It traded at $164 in June, and I fully believe it will blast past this point as some point in the not-so-distant future. If it went back to $124 before August 30, I would be forced to sell the stock at $112, netting me a loss (missed profit) of $12/share, $1,200 in total. This is a bad deal, as we only made $520 selling the covered call in the first place. And the more bullish you are, the better the stock does past the strike price, the worse this strategy is.
Covered calls effectively limit your upside potential significantly, and to me, that is not a balanced trade-off for the downside protection it offers in reducing my cost basis for the position in total. This works fine on a slow-moving stock, but not on something that I am highly bullish on.
The most common comment here is “but you can just roll the option”, and — yes, you can — but that only really helps, if I believe that it will revert back down. Otherwise, sooner or later, I will have my position called away from me as a loss, compared to the stock price at the time.
ALTERNATIVE OPTIONS STRATEGY
My alternative strategy is only relevant on stocks that you are highly bullish on and only really work if it is done on margin. Instead of using a covered call, I want to sell a cash secured put on the stock position.
Instead of selling a Covered Call $10 above the current price, I sell a put $10 below the current price. If the stock price rises or trades sideways, the put will expire worthless, just like the covered call would if the stock price fell or traded sideways. My potential risk here is not if the stock goes up (which is what I am betting on, and not want to limit) but if the stock price drops.
Let’s examine when will happens if it does.
I have capital of $10,000. I then sell a put with a strike $10 below the current price of $100. This $90 put is sold on the same expiration as the covered call above and will net me $4.4/share or $440 for the total contract.
At this point, I have no upside limitations on my stock position, but the naked put has both generated a bit of cash flow equivalent to roughly 4.8% of my initial investment ($440/$9,000) and obligated me to buy an additional 100 shares of the price drops below the strike.
It is obvious to everyone that if that does not happen, the strategy works fine. But what happens IF the stock price drops below the strike, and I then run the risk of getting assigned an additional 100 shares? My solution is to simply sell my long position and wait to get assigned from the put.
The worst situation would be if the stock completely tanked and dropped to something like $85. Here I would still be forced to buy the shares via the put at $90. In fact, it is good to own the 100 shares of the asset, and still collected the premium from the put.