5 Benefits of a Covered Call

New York Financial DistrictPurchasing stock to hold for the long term can be harrowing. In October the market swooned, only to recover all it’s losses. The drop could have easily taken an investor out of a position.

Using a covered call, with the five benefits we discuss here, could keep an investor in a position that would otherwise have been sold in a market dip. A covered call offers five distinct benefits:

  1. Smooths Volatility
  2. Creates Income
  3. Reduces the Cost Basis
  4. Takes Advantage of Time Decay
  5. Provides Staying Power

Smooths Volatility

Selling a call short on a somewhat volatile stock can smooth the up and down price gyrations. If the stock is volatile the premium will be higher, which will in turn provide more of a cushion when your stock drops in price.

The call in effect smooths the overall price swings and their impact on your trading account. This smoothing can be important whether you are managing money for others or using the covered call in your own account.

Selling Calls Creates Income

Many investors will not buy stocks that do not provide a certain level of dividend income. If your investing style, or restrictions, keep you from buying stocks without dividends you can use the covered call to create an artificial dividend.

Rolling the covered call every few months will provide a nice income stream on a non-dividend paying stock. Or, it can be used to enhance the dividend of a stock that already pays a dividend.

Cost Basis is Reduced

Many investors focus on cost basis when investing and trading. Your cost basis determines your profit or loss on the investment, but the cost basis does not have to be a static figure.

You can use the income brought in from a covered call to track and reduce your cost basis. You can in essence make money on a stock that either goes sideways or even slightly down using a covered call. Reducing your cost basis equates to making a profit on the investment.

Time Decay is a Friend

The majority of money made in options is made by sellers of options. As time passes the value of an option (or the premium) falls, and as a call seller you make money from the time decay.

The underlying stock doesn’t have to move at all for you to profit from a covered call. It’s a great feeling to be in a stock that is going nowhere, but still be making money. As the covered call gets closer to expiration the rate of decay will increase.

Covered Call = Sleeping Better at Night

Having a covered call in place can provide a great deal of psychological comfort when you are in a position that tends to be volatile. Staying power can be very important in a volatile market, and a covered call lends strong support to your investment.

If you know rolling you’re covered calls will bring in 10% in the course of a year then a 5% correction in your stock looks less daunting. The covered call can keep you in a position that you otherwise may have sold in a market pullback.

Currently, I like covered calls on:

  • Verizon (VZ) – which is near the top of a range
  • Bank of America (BAC) – near the top of a range, and a possible double top
  • AT&T (T) – range bound, use the covered call to enhance the dividend
  • Dupont (DD) – Near the top of a range, but would use a higher priced, longer duration call

Remember, while a covered call works well in defined situations, one thing it should not be used for is protection. The hedge provided by a covered call is VERY limited.

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