Today I’m going to be outlining, in my opinion, 3 of the best stocks for covered calls. They are:
- Johnson & Johnson (JNJ)
- Proctor & Gamble (PG)
- Pepsi Co. (PEP)
In this article I’ll breakdown why I like these three companies for a covered call strategy. I’ll also give some key context around a covered call strategy.
What is a Covered Call?
Basics
A covered call is when you sell, or “write”, a call option on a stock, or “underlying” that you already own. Writing a call option means that you are selling an obligation, not a right, for the purchaser to buy your shares at a particular price. These call options have an expiration date, a strike price (the price that they can buy from), and a premium.
The premium is what the purchaser pays you in order to have the right to enter into this contract. So as the seller, you could theoretically collect a premium and have the option expire worthless if the share price does not reach the strike price (plus the premium paid).
The “Covered” part of a covered call means that you own the shares you are writing the call option for. A “naked” call is when you write a call option for shares you don’t own. This is completely different and extremely risky.
How is the Premium Determined?
A covered call premium is determined, primarily, by four key variables:
First, the length of the contract. The longer the contract, the higher the premium, and vice versa.
Second, the volatility of the underlying. A very steady trading company will trade at lower premiums versus a more volatile stock. This can be measured via the share price standard deviation or its Beta.
Third, the strike price. For a call option, the closer the strike price is to the actual share price (or less than the share price), the higher the premium will be. The opposite is the case for strike prices well above the current share price.
Fourth, liquidity. The more liquid a stock is for options, the lower it tends to make premiums.
When do you Break Even?
As a side note on terminology. An “in the money” call means that the strike price is less than the current share price. Out of the money means than the strike price is greater than the current share price.
Now that that’s out of the way, when does the purchaser break even on a call option? It’s quite simple:
Break-Even Share Price = Strike Price + Premium Paid
So as the seller, you want the share price to be less than the strike price plus the premium the purchaser paid. It’s as simple as that!
What is a Covered Call Strategy?
A covered call investing strategy is an income producing strategy where you sell, you guessed it, call options. Investors like to do this to make extra income for shares that are “just sitting there”.
Upsides of a Covered Call Strategy
The upside of this is, if you play it right, you may never get called and you just earn some premiums over time. Some investors think of it has “maximizing” their returns by selling these options.
It is rarely that simple, but it is undeniable that it is POSSIBLE to earn outsized returns with this strategy. But the opposite is also true… which leads me to downsides.
Downsides of a Covered Call Strategy
The downsides, or challenges of this strategy, are several key things.
Long-Term Implications
First, as the seller of the covered call, you are technically SHORT the underlying. As the seller, it would harm you if the underlying performed too well and exceeded the strike price.
Depending on what strike price you choose, this could be either extremely likely or unlikely.
This means that over long periods of time, you will almost certainly be called and have to sell your shares at a below-market price. This obviously assumes stock prices go up over time, which has happened the last 100 years!
Bottom line, you are trading set premiums in exchange for variable upside. As stocks continue to rise, this will almost certainly limit your TOTAL return.
Volatility Effects
Second, premiums on call options are eroded as the underlying price drops. Here’s an example:
You own a XYZ stock at a share price of $10 and you write a call option at a $15 strike price with a $1 premium. XYZ then plummets in share price to $2 per share.
This is good that you didn’t get called, but now you’re stuck holding this thing! To make matters worse, to generate premiums via more covered calls, you have to drop your strike prices.
Now to get a $1 premium, your strike price needs to be $3. But say the company then rebounds back to where it was a few months later… your stock just got called away at $3!
See where I’m going with this?
All in all, volatility makes a covered call strategy very difficult and makes premium income unreliable.
3 of the Best Stocks for Covered Calls?
Now I probably didn’t sell a covered call strategy as the greatest thing ever. But I do think it has its place in a more seasoned investor’s portfolio who is looking for some steady income in exchange for upside.
Given that, I’ve picked three stocks below that I think are great options for selling covered calls.
- Johnson & Johnson (JNJ)
- Proctor & Gamble (PG)
- Pepsi Co. (PEP)
Why these three companies?
The main thing: volatility and covered call options do not mix well for a more risk averse investor. I am one of those investors. I want to sell covered calls on a more steady company where I can more reliably analyze an appropriate strike price.
Each of these companies are extremely steady growers and do not experience as much volatility as the broader market. Each have Beta’s near 0.5, which is a perfect level in my opinion.
This means I am sacrificing additional premiums in exchange for lower risk of being called. This is my personal preference, but if you can handle the risk – go for more volatile stocks! Power to you!
The last thing of note is that these companies have very liquid option chains. I almost never suggest anyone try to trade options into an illiquid market.
Bottom Line
You should now understand what a covered call is, what a covered call strategy is, and the upsides and downside are.
This is not for a rookie investor, but it’s also not as hard to get into as you think. I just stress that you understand exactly what you are mathematically doing in this strategy: you are short the underlying, you are trading variable upside for a set premium, and premiums are unreliable.
Hopefully this was helpful and happy investing!
DISCLAIMER – THIS ARTICLE IS NOT FINANCIAL ADVICE. THIS ARTICLE DOES NOT CONSTITUTE A BUY, SELL, OR HOLD RECOMMENDATION ON ANY SECURITY MENTIONED HERE. THIS ARTICLE CONSTITUTES MY OPINION AND NOT A STATEMENT OF FACT. ALL INFORMATION REGARDING THE FINANCIAL SECURITIES MENTIONED IS ACCURATE AS OF JANUARY 24, 2024. DO YOUR OWN RESEARCH.