How much money you want to make is often (if not always) a function of how much risk you want to absorb. Someone with a particularly high appetite for risk can go on a road trip to handing out checks to undergraduates in hopes of catching the next big thing while it rattles around the dormitory. Someone with a particularly low appetite for risk can invest in Treasury debt and savings accounts.
Yet, “Even conservative investors can earn fine total returns via covered call writing if they’re willing to shoulder just a small amount of risk,” Paul Price wrote recently on Real Money.
Fear of missing out, however, can lead to missed opportunities, Price writes, noting that “some people will balk at capping their upside and ‘missing out’ on even larger gains.”
Price looked at one of his favorites to illustrate the point. “Regular readers of my columns know I love shares of footwear designer and retailer Caleres (CAL) – Get Caleres, Inc. Report. It is my single largest dollar holding.”
Recently “CAL posted the best end-of-July quarter in its entire history. Management raised earnings guidance for the fiscal year ending Jan. 29, 2022 to a range of $3.25 to $3.50 per share. That represents about 50% above the firm’s previous all-time record.”
Currently the stock is “selling for just 6.6-times the mid-point of this year’s estimate, accompanied by a 1.26%, well-covered current yield.” By contrast “a typical multiple for CAL runs about 14-times, implying a present day fair value of about $47.25.”
Now, “suppose you just bought 1,000 shares of CAL on Monday morning for the market price of $22,230. Because CAL is volatile, and because it has serious upside, option buyers are willing to pay generous premiums to own call options out to January, May or December of next year.”
That means “covered calls are one way to create a hedged position in the market. By selling them you can establish a position with a maximum upside, but also a capped potential losses. While somewhat technical, it’s an excellent risk-mitigation strategy for investors who’d like to capture some of the gains from a potentially hot stock without necessarily exposing themselves to all of the volatility.”
Why does Price think this might be a particularly good move for volatile stocks like CAL? Because “selling covered calls reduces per share risk by the exact amount collected up front. It also levers potential gains by rebating some of the money laid out to purchase the shares initially.”