Commonly touted as a gateway strategy, covered calls provide an alluring introduction to the options realm for stock traders looking to not only improve returns but also score downside protection. Due to their simplicity, they provide an easy transition into the derivatives and lay the groundwork for a trader to grow into more complex strategies. To those otherwise unfamiliar with the structure of a covered call, it consists of purchasing 100 shares of stock and selling a call option. Much has been written about the merits of covered calls and the proper approach to selecting the appropriate strike and expiration month.

Rather than bogging ourselves down with a variety of details, today’s article will focus on one particular aspect of this strategy.

While traders can analyze a variety of metrics such as the return if assigned, return if unassigned, and amount of downside protection, one which I like to add to the mix is what could be called the “line of demarcation.” Consider this price the point at which stock ownership will yield a better return than a covered call. If the stock rises above this line, you will capture a superior profit by not selling the covered call. If the stock remains below the line, covered calls will yield a better return. Those inclined to forecast price direction can assess how likely the stock is to rise above the demarcation line by expiration. If they believe the chances are slim, the covered call should look even more appealing. Conversely, if they believe the chances are high, then it may not be the best time to short call options. Or, it might make more sense to sell a higher strike call, thereby lifting the demarcation line.

Upon gaining a proper understanding of this concept, it becomes easier to see why covered calls outperform stock ownership in all but the most bullish of markets. By incorporating this line in the sand into your analysis, you can more strategically select when selling covered calls is appropriate, or better yet, which strike price is optimal to use.

You can calculate the line of demarcation by adding the premium to the strike price. Suppose you were considering the following covered call on DBA on October 28th. You originally purchased the stock at $29 and were considering selling the November $30 call option for 50 cents. By adding the premium (50 cents) to the strike price ($30), the line of demarcation
comes out to $30.50. Consider the chart below, which not only highlights the line of demarcation but also shades the areas where stock ownership or the covered call trumps.

If you thought DBA was poised to break significantly above $30.50, you should pass on the covered call, or perhaps considering selling a higher strike such as $31. On the other hand, if you thought the odds of a surge higher than $30.50 were low, then you should probably sell the covered call.

Using the demarcation line in your analysis presumes, of course, you can forecast price direction. Those uncomfortable with chart reading who lack any edge in predicting the future movement of a stock may not want to use this in their analysis. Instead, they may focus more on the amount of downside protection or return on investment offered by the covered call in question. Traders inclined to predict the odds of the stock breaching above the demarcation line may consider analyzing the current trend of the stock, momentum, and support or resistance levels of note. The primary reason in identifying this line is to ensure you’re not selling call options on aggressively bullish stocks. One of the inherent drawbacks to covered calls is their limited reward. It can be frustrating to lock yourself into a 5% gain on a stock that proceeds to climb by 20%. The odds of this happening should diminish once you start considering the line of demarcation as part of your analysis.

Covered call traders have a variety of tools at their disposal to assist in their decision-making process. Adding the line of demarcation to the mix will add some color to the analysis by ensuring the covered call fits a trader’s outlook on the stock.

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