This is the third segment of my series on mistaken ideas about options trading.
No. 3 below is technically correct about covered call writing capping potential returns. But I take exception to the view that call writing is unacceptable for that reason.
There is no doubt that once a call is sold, you have limited your upside.
Isn't that exactly what happens every single time you sell a stock? Doesn't that occur each time you place a limit order to sell? In both cases you accept either the current quote or some pre-determined future price as your upper limit before exiting.
The key to good covered call sales is only writing options that you'd be fine with if they get exercised. If you are selling premium to get income, then you shouldn't be disappointed if it's exercised, provided you liked the initial call price in relation to the value of the underlying shares.
Yesterday's example of selling the Xilinx (XLNX) March $45 call for $1.29 illustrates the math involved.
Buyers of XLNX at $41.22 who sold March $45 calls for $1.29 had net outlays of $39.95 per share after commissions. The $1.28 net call premium equals 3.2% of the total outlay for 235 days (0.64 year). That equates to a 5% annualized synthetic dividend on a 9.1% out-of-the-money strike price.
Covered writers are still entitled to collect any normal cash payments that go ex-dividend prior to exercise. Xilinx is expected to pay three 29-cent quarterly dividends between July 28 and the March 20, 2015, expiration date. Unless call option sellers are exercised early, they will likely receive the $0.87 along with the call premium. That's an already decent yield was made much better through the sale of covered calls.
If the stock is called away on expiration date, the total return would be quite decent at $5.92 per share on a net $39.95 initial outlay. That represents a best-case 14.8% gain in under eight months, or 22.98% annualized.
Is that really an unacceptable rate of return?