How to Hedge Your Portfolio with Covered Calls

By Andrew Horowitz

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Remember that in our last episode, we discussed reasons you might want to hedge your portfolio during certain periods of market uncertainty. Hedging is not very efficient when the market is skyrocketing upwards or plunging downwards. In the event of a skyrocketing market to the upside, hedging your portfolio will prevent you from making as much money as possible as the market rises. On the flipside, when the market is plunging like in September and October of 2008, you may want to consider being fully out of the market, in cash, or in bonds because the hedges you put on may not offset the major down-move in the market.

When Is the Best Time to Hedge?

Many hedges are best taken when the market is either slowly rising, or slowly falling, or more appropriately just sort of drifting sideways without a main direction. Remember, nothing says you have to be fully invested in the market, but if you see a short-term bumpy road ahead, it's okay to put on a hedge instead of running for the hills and selling everything you own. 

Remember, nothing says you have to be fully invested in the market, but if you see a short-term bumpy road ahead, it's okay to put on a hedge instead of running for the hills and selling everything you own.

When to Use a Covered Call

Let's first start with one of the most popular methods investors use to hedge their portfolio or any specific stock market position for a short period of time. It's is the covered call. It uses options; but if you have never traded an option, don't worry. We will discuss those in a future episode, but for now, we'll just talk about covered calls.

(As a side note, in my book The Disciplined Investor - Essential Strategies for Success, I have a whole chapter dedicated to options. Pick it up at Amazon, I will provide a link on the show notes for this episode at quickanddirtytips.com)

Let's say you did your fundamental analysis and technical analysis and found that Walmart (WMT) was a good stock to buy for the long term. So, now you purchased Walmart for your portfolio for the long-term and you're going to collect dividends and any potential price appreciation from the stock.

However, you think that Walmart might have a bad quarter ahead, or will decline in value over the next few months--but not enough to spook you out of your position entirely. You may ask your broker to sell a covered call for you, or you would just sell a covered call in your own brokerage account.

What is a Covered Call?

So, what is a covered call? It is an intermediate level investment tactic that you do when you already own a stock and you go out and sell a call option as a hedge to try to take in what's called "premium." That will turn into a profit for you if the stock doesn't move much or actually declines a little bit.

Let me explain: Let's say you bought 100 shares of Walmart stock at $45 per share a few months ago, and now Walmart trades at $49 per share. You think that the price might decline a little bit over the next two months so you take a look at the call option price for $50 per share in Walmart over the next two or three months. You can find the price of call options by selecting the "Options" tab at Yahoo Finance, Google Finance, MSN Money, or any free online financial website.

In our example, let’s say that it's the beginning of October and you then take a look at the December $50 call options for Walmart and discover they are trading for about $2 dollars per contract. To execute the covered call, you would sell one call option contract and you would take in $200. Remember, that each option contract is equal to 100 shares of stock , so you would need to divide how many shares you own by 100 to see how many options contract you would need to sell.

How Do Covered Calls Work?

Here is where it gets fun. Let's fast-forward to December. Your call options expire in the middle of the month of December--all options expire the third Friday of each month. Now, we're there in the middle of December and the price of Walmart stayed in exactly the same position and closed at $49 per share. You would get to keep the premium or money from selling those options contracts and you still own your stock! That's an extra $200 that your hedging strategy gave you that you would not have had if you did not hedge.

Let's say that Walmart fell back to $45 in December, which is where you bought it originally.  You would still keep the $200 and you would still own Walmart stock for the future, but you'd be $200 richer per hundred shares you purchased.

This all sounds great, but remember, hedging is like insurance. What would happen if the price of Wal-Mart went above $50 per share?

What Happens When You Sell an Option Contract?

When you sell an option contract, you give someone else the right to purchase the shares you own if the price of the stock rises above the value you sold the option, which is $50 in this case. You would have to sell your shares at $50 if the price of Walmart went above $50 in mid-December, but remember, you still get to keep the $200 no matter what happens. And you won't lose any money if you have to sell your shares so you are still okay.

This just means that if the price of Walmart is--let's say --$55 in December, you would not get to participate or enjoy the upward action over $50. You basically put an upside cap on how much you can gain from Walmart stock if the price goes up, but you give yourself a little cushion and get to keep the shares if the price is under $50, which is what you suspected in the first place.

If you want to, you can go back and buy more shares of Walmart if you feel the fundamental and chart picture is still strong!

When You Don’t Want to Sell a Covered Call

If you think the price of Walmart is about to fall from $50 to $40 over the next two months, you would not want to sell a covered call because the $2 per share you get will not be enough to offset the loss of the $10 per share you may lose. You would be better off selling Walmart right now and waiting to buy it back, or using the money to buy some other stock that you may believe is going up.

That's enough about covered calls for now! I hope I didn't confuse you too much, but that I gave you a quick and dirty tip of how to use covered calls to hedge stocks in your portfolio if you think price is going to stay flat or go down just a little bit over the next few months.

Keep with us as we discuss even more ways to become a winning investor in our next podcast! If there’s a question you’d really like to ask, just email me at winninginvestor@quickanddirtytips.com.

And if you like the show, tell a friend or leave a review on iTunes. Until next time, this is Andrew Horowitz with The Winning Investor’s Quick and Dirty Tips wishing you all the best on your quest to investment success.