Covered Call Due Diligence: Key Performance Metrics to Know
Jesse Anderson
Covered calls are a time-tested options strategy to boost portfolio income in sideways or moderately bullish markets. While the basic mechanics of covered calls are straightforward (and we’ll review them below), measuring and optimizing their performance requires a nuanced understanding of several key metrics.
In this article, we’ll take a look at the key metrics you need to know to evaluate whether covered calls are a good fit for your investment goals and decide on the best trades.
What Are Covered Calls?
Covered calls combine stock ownership with the sale of call options, creating a strategy that generates immediate income in exchange for limiting upside potential. They’re a popular strategy for retirees looking to supplement their income without drawing down their investment portfolio or relying on fixed-income markets.
To illustrate how they work, suppose you own 100 shares of a stock trading at $100.00 per share and sell (write) a call option for $1.00. You’ll generate an extra one percent monthly yield. However, the stock option might have a strike price of $110.00, which would limit your upside potential to $10.00 per share for the next month.
There are several reasons you might consider a covered call:
- Pure income: Generating income by picking stocks based on their potential to generate income using covered calls (e.g. buy-write strategies).
- Supplemental income: Generating extra income above and beyond dividends by selling (writing) call options against existing stocks.
- Buffering against losses: Selling (writing) call options to generate income to offset an expected modest decline in the stock price.
Depending on your investment goals, you might choose different metrics to measure success. For example, pure income investors might be more interested in annualized yields than downside protection. That said, you should look at multiple indicators to understand how covered calls might affect your outcomes.
Covered Call Performance Metrics
Successfully implementing a covered call strategy requires careful attention to multiple performance indicators that collectively provide a comprehensive view into the strategy’s effectiveness. While some indicators may be more relevant to you than others, it helps to have a holistic understanding before diving into a covered call position.
In the following examples, we’ll assume you have a hypothetical stock position of 100 shares in Acme Co., which trades at $50 per share, with a covered call written at a $52.50 strike price, 30 day expiration, and a $1.00 premium.
Premium Income
The most obvious reason to write a covered call is to generate premiums that boost your monthly income. If you’re concerned about generating a set dollar amount each month, you might look at the actual premium income in dollar terms for a covered call position to see if it meets your income requirements.
In our example, selling one covered call contract would generate $100 in immediate premium income that you might be able to repeat monthly.
Downside Protection
Covered calls also provide downside protection by offsetting some losses with premium income. So, if you’re on the fence about selling a stock you own because you anticipate a little downside, you could look at the downside protection offered by a covered call and potentially avoid a taxable event and keep the stock in your portfolio.
In our example, the $1.00 premium reduces the effective cost basis of Acme Co. from $50.00 to $49.00 per share. So, the stock could fall 2% (from $50.00 to $49.00) before the position incurs any actual loss.
Return If Called / If Flat
Depending on your market outlook, you might want to compute the if-called or if-flat return to understand how things might play out. If-called return reflects the maximum upside potential when the stock moves past the strike price. If-flat return tells you how much you’ll earn in a sideways market, assuming the stock price remains the same.
In our example, if Acme Co. rises above $52.50, the shares would be called away. The total return would combine three elements: The $1.00 premium, the $2.50 gain on the stock, and any dividends you received. In this case, the if-called return would be $3.50 per share, or $350 for all 100 shares, representing a 7% return over the 30-day period.
On the other hand, the if-flat return assumes a $50.00 share price at expiration. This represents a 2% return over the 30-day period, which is not a bad outcome in an otherwise sideways market!
Annualized Return
Conceptualizing monthly returns can be challenging when comparing covered calls to other income-generating strategies. The example above demonstrates using covered calls for a 30-day period. Under ideal conditions, you could repeat the process 12 times throughout the year to produce an annualize return. By computing the annualized return, you can make apples-to-apples comparisons between covered call yields and things like dividend yields or bond coupons and ultimately make smarter financial moves.
In our example above, we can annualize returns by multiplying the period return by the number of periods in the year. So, the so-called 7% 30-day return would translate to 84% on an annualized basis (7% per month x 12 months).
Building a Better Strategy
Successfully investing in covered calls requires carefully balancing these performance metrics while considering your individual investment goals, market conditions, and risk tolerance. For example, even if a covered call has strong yield potential, the underlying stock might be too risky to hold in your portfolio.
optionDash helps simplify this due diligence by incorporating these key performance metrics alongside other research tools. For instance, you can narrow down options that suit your portfolio while easily assessing a company’s trend, value, and growth potential using our proprietary scoring formula.
optionDash makes it easy to see these key metrics and even filter by them. Source: optionDash
Of course, these key metrics aren’t the only factors that go into choosing the right call options to execute a covered call. And you need other skills—like knowing when to roll up or roll out a position—to become a successful covered call investor. Fortunately, free e-courses like those offered by Snider Advisors can help you get up to speed!
You may even choose to implement an option wheel strategy, which combines covered calls with cash-secured puts. Using this technique, you write cash-secured puts until you are forced to buy a stock. Then, you write covered calls against the long position until you’re forced to sell the stock. Of course, you then repeat the process.
The Bottom Line
Covered calls are a popular way to boost portfolio income. While they are straightforward to implement, knowing a handful of key performance metrics can help you decide on the best options for your portfolio in a particular investment climate. Fortunately, tools like optionDash and courses from Snider Advisors can help level up your skill set.
Get started with optionDash for free!
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