The covered call strategy is widely used by investors seeking income or protection by selling call options on stocks they own. For instance, if you own 100 shares at $50 each and sell a call for $2 per share, you would earn $200. Though this generates income and mitigates some risk, the investor might be required to sell their shares at the option’s strike price if the stock value increases significantly.
The inherent flaw in the standard covered call strategy is the limited profit potential and unlimited, although slightly reduced, risk. Therefore, sophisticated investors prefer options that are quite out of the money, reducing the risk of their shares being called while earning income. However, a significant capital investment creates the risk of a low return-on-investment.
An alternative strategy involves buying a longer-dated call option instead of the physical shares and purchasing more options than sold, creating a calendar spread situation. This provides a lower-cost, higher potential yields, and less risk.
To illustrate, let's say a stock is trading at $46.56, and you buy 100 shares and sell a December 45 call option for $5.90. The breakeven price, in this case, would be $40.66. The trade's maximum profit would be $434, an approximate 10.7% return on an investment of $4,066.
Now, let's consider another strategy. Here, we buy three January 40 calls for $10.80 each and sell two December 45 calls for $5.90 each. The maximum risk and cost to enter this trade is about half of the regular trade, roughly $2,060.
Suppose the stock price increases sharply from $46.56 to $68.20. The later strategy offers a potential profit of $1,850 on an investment of $2,060, an approximately 89.8% return.
Please note, while the alternate strategy visually seems more profitable in the given scenario, it does not guarantee better performance than the standard one. However, these examples do showcase how options can be used to craft trades with a much higher profit potential compared to buying stock or using standard hedging.