Revisiting Covered Calls

It's been a while since we've looked at the covered call position, but the recent market correction provides a good time to use this strategy as a way to buy stocks at an even steeper discount to current prices and reduce the volatility of your portfolio.

Despite the fact that the VIX, which measures the implied volatility of S&P 500 index options, remains stubbornly stuck near eight-year lows, the sharp selloff in some individual names has prompted the implied volatilities of their related options to rise to their highest levels in nearly a year, making the sale of option premiums attractive.

The covered call is popular because it's a straightforward concept strategically aligned with the natural bias toward stock ownership while being relatively simple to execute. Covered calls will lower your overall risk/reward profile but still leave room for substantial short-term gains. They also offer a simpler alternative to some of last week's strategies for a sideways market. Remember, the covered call is most effective when applied to stocks with prices that remain constant or rise in a slow and steady fashion.

Here's a quick example of the basic covered call position: a long position in 1,000 shares of XYZ trading at $49, while selling 10 XYZ calls with a $50 strike for $1 a contract. As a hybrid position combining both the underlying security and offsetting option, it has a reduced risk/reward profile when compared to being either outright long the stock or just short the call.

Equal but Not the Same

To qualify as a valid covered call, both the stock and the option must be in the same account, the long stock must be the same underlying security specified by the short option, and you must hold at least enough shares of stock to fulfill the delivery requirement of the call option. These criteria are important because they determine in what type of account the position can be established, as well as the margin and maintenance requirements.

I've mentioned these requirements because some people will point out that selling a put option short (i.e., "naked" or uncovered) offers a similar profit/loss profile as a covered call but requires less capital and can be established through a single transaction. But it's important to note that many brokerage firms may not allow individuals to sell naked options because they're more highly leveraged and therefore, in percentage terms, a riskier position.

Also, for stocks that pay a dividend, using a covered call can be more valuable than selling put options, because owning the underlying shares let you collect the dividend payments. For example, despite posting strong earnings this morning, shares of J.P. Morgan ( JPM) were down 1.5% and tumbled a full 10% over the last three weeks on concerns that rising rates will hurt performance.

But at current levels, the stock provides a dividend yield of 3.6%, making it an attractive core holding. By writing calls against the long stock, you can reduce the short-term risk associated with interest rate concerns and hopefully generate some incremental short-term income.

Get Paid to Assume Risk

When looking at any option position, it's always important to look at the current implied volatility relative to the underlying stock's historical or actual volatility -- not just the absolute number -- in determining whether on option is "cheap" or "expensive." The theory is that if you're going to take on risk, you should be paid accordingly. Selling "expensive" calls against a long position in the underlying shares is one way to add higher-risk stocks while reducing exposure. Selling the call not only cuts your cost basis but also establishes a way to make profits at a specified price level.

One way to find attractive covered call candidates is to screen for stocks that have declined at least 20% over the last 30 trading days and have options with an implied volatility that is within 10% of their 52-week historical high. It's not too big a surprise that the technology sector has proved the most fertile ground for generating names that meet this basic criteria.

For example, on Wednesday morning Foundry Networks ( FDRY) was trading at $16, down some 31% from its March 10 closing price. Its May $17.50 call was trading around 80 cents, or $80 a contract, giving it an implied volatility of 69%; this is well above the 30-day historical (actual) volatility of 50%, and just 8% shy of the 52-weak peak of the 75% hit on March 16 when the stock took its initial tumble, but well above the 42% implied volatility hit last December.

A current covered call position in Foundry Networks, in which you can buy the shares at $16 (a level that seems to offer some technical support) along with selling the May $17.50 call, seems like an attractive proposition. It provides a break-even point of $15.20, or a 5% discount to the current market price.

The maximum profit, or the crossover point at which the gains in the long stock will be offset by losses in the short calls, is $18.30, which would be a 14% profit (excluding commissions, margin requirements and so forth). That's not bad for four weeks of work, translating into a return of 172% on an annualized basis.

Given its recent drubbing, Nokia ( NOK) also might be right for creating a covered position. There is certainly a case to be made that at $15, the stock currently represents value. But when a stock gets knocked down by about 25% in the span of three days, it may take some time to stabilize. On Wednesday morning, you could sell the May $15 call for 70 cents, not the richest price with 36% implied volatility, but a nice way to generate income of 5% off a stock that may be mired at current levels and needs a month to mend.

Takeover Candidates

Stocks in the takeover rumor mill typically see their options' premiums, especially the front- or near-term expiration, get pumped up. A previous article looked at strategies involving skews, which basically involved creating a calendar spread or the sale of the more expensive short-term option against the simultaneous purchase of the relatively less expensive longer-term option. But a covered call can accomplish a similar feat without the risk that an all-cash or sooner-than-expected takeover bid brings to owning longer-dated options.

One particularly attractive candidate is OSI Pharmaceuticals ( OSIP), which at $38.40 offers a May $40 call at $4.20, or an implied volatility of a whopping 110%, providing for an effective purchase price or break-even level of $34.20, or a 10% discount to current prices. This would give you a profit potential of 15% should the shares close above $40 at the May 21 expiration date.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to steve.smith@thestreet.com.

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