Smart Investor: Enhance portfolio income with covered calls on blue chips

The table above lists various blue-chip stocks along with their implied volatility (IV) rank. IV Rank is a measure that compares the current implied volatility of a stock to its range over a specific period, often a year. A higher IV Rank indicates that the current implied volatility is relatively high compared to its historical range, potentially allowing investors to collect higher premiums when writing options.

In this bullish environment, covered calls serve a dual purpose:

1. They enhance yield by providing additional income through option premiums.

2. They act as a buffer against market pullbacks. If the market consolidates or corrects after a strong run, the premium collected helps offset some of the potential downside.

Setting up a covered call strategy: step-by-step

1. Own the stock: Investors must own at least 100 shares of the blue-chip stock to write the covered call. This is a crucial requirement for the strategy to be considered "covered."

2. Choose the right stock: Consider selecting a fundamentally strong blue-chip stock with consistent price stability and a reliable dividend. Stocks like Microsoft (MSFT), Coca-Cola (KO), and Johnson & Johnson (JNJ) are suitable candidates due to their stability and high liquidity.

3. Avoid earnings dates: It may be prudent to avoid opening positions close to earnings dates. Earnings reports can cause significant price volatility, potentially moving the stock beyond the strike price and putting the call in-the-money (ITM). Selecting expirations that do not overlap with earnings announcements can help minimize this risk.

4. Select the expiration date:

   • Monthly expirations: Monthly options strike a balance between earning sufficient premium and managing time decay efficiently. It’s a practical timeframe for generating consistent income without frequent adjustments.

   • Weekly options: For a more active approach, weekly options offer flexibility and frequent income opportunities but require more management.

5. Choose the strike price:

   • Aiming for a strike price with a delta of around 0.20-0.30 may allow for decent premiums while maintaining room for stock appreciation.

   • Avoiding strike prices too close to the stock price (ATM calls) can reduce the likelihood of assignment if the investor prefers to keep the shares long-term.

The image above shows an options chain for Nike (NKE), highlighting call options. Delta is an important metric shown here, representing the sensitivity of the option's price to changes in the underlying stock price. A higher delta means the option will move more in response to the stock price movement, which is crucial for covered call strategies.

Managing covered calls: what if the stock goes ITM?

If the stock price moves above the strike price, putting the covered call ITM, there are several ways to manage the situation:

• Roll the call: If retaining the shares is a priority, an investor can “roll” the call by buying back the current option and selling another one with a higher strike price and/or a later expiration date. This approach allows the investor to keep the shares while collecting additional premium.

• Ex-dividend risk: Be mindful of ex-dividend dates. If the call option is ITM and the ex-dividend date is approaching, there is a risk that the option holder may exercise early to capture the dividend. To avoid this, set expirations after the ex-dividend date or choose OTM strikes to reduce the likelihood of assignment.

Calculating yield and setting realistic targets

Yield calculation is essential for assessing the performance of a covered call strategy:

• Premium yield = (premium received / stock price) x 100. For instance, if $2 is collected on a stock priced at $100, the yield is 2%.

• Annualized yield: This can be calculated by multiplying the yield per trade based on how often the strategy is executed annually. For example, if the monthly yield is 2%, rolling monthly could lead to an annualized yield of around 24%.

For blue-chip stocks, an annual yield of 8-15% is often achievable when accounting for premium income and dividend payments. Higher-volatility blue chips might yield up to 20%, but this carries additional risk.

Generating consistent income with covered calls

• Monthly plan: Selling monthly calls with OTM strikes (delta 0.20-0.25) can balance premium collection and the likelihood of stock retention, generating consistent income while providing some buffer for capital appreciation.

• Weekly approach: For more active investors, weekly options provide opportunities for frequent income generation but require closer monitoring and management.

Potential risks and mitigation strategies

While covered calls are a conservative strategy, they come with certain risks:

• Opportunity cost: If the stock rallies significantly beyond the strike price, the investor might miss out on large gains. Choosing OTM strikes can mitigate this, allowing some stock appreciation while still earning premium.

• Assignment risk: ITM options may be assigned early, particularly around ex-dividend dates. Avoiding ITM calls before these dates can help, unless the investor is comfortable selling the stock.

Conclusion

Covered calls on blue-chip stocks offer a reliable way to boost portfolio yield, especially in today’s bullish market. By selecting stable, high-liquidity blue chips, investors can consistently earn premium income while retaining the potential for capital appreciation. Whether aiming for monthly or weekly income, covered calls provide flexibility tailored to various investment goals.

By strategically managing expirations, strike prices, and dividend schedules, investors can maximize yield while keeping risks under control. This approach can enhance portfolio performance in a manner consistent with conservative income strategies.