Covered calls are a conservative options strategy used by hedge fund managers, professional market players, and individual investors. Here’s how covered calls work and when to consider using them in your investment portfolio.
Using the covered call strategy is simple—you sell one contract and repurchase one within a specific time. With covered calls, you can generate income from your stocks even when they’re not increasing in value.
Discover how to sell covered calls, uncover the strategy’s advantages and disadvantages, and get an overview of the risks involved. Learn how to sell covered calls and create unique investment exposure for your portfolio.
Owning the stock and writing covered calls is known as ‘call option selling’.
If you are confused about the appeal of this strategy, learn how it can complement your investment goals.
Table of contents
- What is a call option?
- What is a covered call?
- How to profit from covered calls?
- How to sell covered calls?
- What are the scenarios of covered calls writing?
- Third scenario:
- What to Do at Expiration?
- What are the risks of Covered Call Writing?
- What are the advantages of selling covered calls?
- Can I sell the stock before the covered call expires?
- Frequently asked questions about how to sell covered calls.
- Conclusion
- References
- Recommendation
What is a call option?
You Should Check Out; How to buy calls option on Robinhood
What is a covered call?
A covered call writer sells calls in stock he owns. In this manner, the covered call writer has essentially traded some of the potential upsides on the stock for a fixed return in the form of an option premium instead.
A covered call is a popular way to generate income from investors who think stock prices are unlikely to rise much further in the near term.
Since call options give their holders the right to buy the underlying stock at the designated strike price, regardless of where it might be trading in the market, sellers of call options, therefore, absorb the obligation to sell the stock to buyers at that strike price if buyers choose to exercise their options.
The seller gets paid by buyers (the option premium) for taking on that obligation and limiting their upside potential on the stock for the duration of their options.
For example, a call option held by an individual would have time until expiration before having to sell the shares held back from him by owning the call since he will only have to deliver any shares if they are exercised.
However, those selling uncovered calls incur unlimited downside risk if they own or acquire new shares above the negotiated strike price since they would have to provide those additional shares if called away, increasing their total exposure.
(Brokers restrict who can sell uncovered calls and require hefty margin requirements as collateral accordingly.)
See Also: Puts Vs Calls: What’s the Difference and Similarities
How to profit from covered calls?
Covered calls are a way to generate consistent income from your long stock positions. You sell a call option on your stock; this way, if the stock goes up, you get paid a premium from its sale, and you keep the stock.
However, you don’t want the call to get exercised by the buyer because you have locked into it for a certain time, and you lose money on your stock sale. Sell a call option against your shares — You own 100 shares of XYZ at $50 and hope to sell it for $60 by the end of next year.
You’ve seen that the stock’s current price is $55. You could sell a six-month call option with a $55 strike price, bringing in $4 per share in premium.
If the stock doesn’t rise above the call price in six months, you keep the money and sell another call later.
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How to sell covered calls?
The process for selling covered calls assumes that the investor has a brokerage account with options approvals and the necessary minimum of $2,000 in equity. (Most brokerage firms will allow covered call writing in cash or margin accounts and IRAs as well).
First, you have or buy 100 shares of stock. Then you select a call option that represents those shares at the desired strike price and expiration date and sells
that call option contract. (Since you’re opening an option position by selling it, your position is said to be “short” rather than “long”.)
Once you have a call or a put to sell, you need to pick the strike price, which is the price at which you are obligated to sell your stock. You also have to decide when you want the contract to expire.
The further out in time, the more premium you’ll get for your option, but that comes with more risk because the stock could skyrocket right past your strike price if it is undervalued on the day of expiration.
What are the scenarios of covered calls writing?
When you write a covered call, there are three possibilities, and each can only happen one at a time. I will list the possibilities and the results of each occurrence:
- The stock price remains at or below the strike price of the option at expiry
- Stock price is above the strike price at expiry
- The call writer repurchases the call option to close the position before expiry
The first scenario:
When the stock is at or below the strike price at expiration. The option will expire worthlessly, and you will have no further obligations. You’ll get the premium you received from the sale of the option.
The second scenario:
If the price is above the strike point at expiry, the writer does not need to do anything as the sales will go through and the stocks will be transferred to the buyer.
Third scenario:
The seller can buy relinquish his covered call by buying it back. This can result in either profit or loss depending on the price of the stock when the seller wishes to buy back the options.
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What to Do at Expiration?
When you write a covered call, eventually, you will reach the expiration day. If the option is still out of the money, it will likely just expire worthlessly and not be exercised.
In this case, you don’t need to do anything. But if the option is in the money, expect to have the stock called away.
Depending on your brokerage firm, everything is usually automatic when the stock is called away.
Be aware of the fees in this situation, as each broker will be different.
You will need to be aware of this so that you can plan appropriately when determining whether writing a given covered call will make sense for your account.
What are the risks of Covered Call Writing?
When considering a covered call, the main risk is missing out on stock appreciation. If a stock surges because a call was written, the writer only benefits from the stock appreciation up to the strike price, not higher.
It’s important to remember that while a covered call is often considered a low-risk option strategy, that is not always the case.
The shares can drop in strong upward moves, causing a significant loss even though the premium income helps offset that loss.
There is also a significant risk when the price plummets instead of rising. In this case, the call would not be triggered, and the seller would have missed out on potential profits and incurred some losses in the process.
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What are the advantages of selling covered calls?
The main benefits of a covered call strategy are that it can generate premium income and boost investment returns. It can help offset downside risk or add to your upside return, taking the cash premium in exchange for the stock at or above strike price earnings per share.
By striking the right balance and finding the right stocks, you can increase profits — or limit losses.
Can I sell the stock before the covered call expires?
Yes, this can be a big risk since selling the stock before the covered call expires will result in it being “naked”. It can be a huge risk since you’d need to sell the underlying stock before the covered call expires. This is akin to an unhedged short sale, and unlimited losses are possible.
Frequently asked questions about how to sell covered calls.
The key to success in covered call strategies is to pick the right company to sell the option on. Then, select the correct strike price. Simple covered calls work best so long as the price of a stock stays below the strike price of the contract.
In general, you can earn anywhere between 1 and 5% (or more) selling covered calls. How much you earn depends on how volatile the stock market currently is, the strike price, and the
expiration date. In general, the more volatile the markets are, the higher the monthly income you’ll earn from selling covered calls.
The maximum loss on a covered call strategy is limited to the price paid for the asset, minus the option premium received. The maximum profit on a covered call strategy is limited to
the strike price of the short call option, less the purchase price of the underlying stock, plus the premium received.
Selling covered calls can help investors target a selling price for the stock that is above the current price.
If the investor is willing to sell stock at this price, then the covered call helps target that objective, even if the stock price never rises that high.
Conclusion
Covered call writing is a commonly held investment strategy that involves combining stock ownership with the ability to sell call options on those shares. Covered call writing brings
many benefits, which include generating income, lowering the price volatility of stock holdings, and hedging downside risks. You will need to give up a portion of the possible upside potential in exchange for the benefits. If you are interested in learning about covered call writing, you’ll have many options available via the listed options.
Covered call writing can generate income, reduce downside risks and boost a portfolio’s overall return. Learn how to sell covered calls with these tips and strategies.
References
- Seeking Alpha
- Fidelity
- Investopedia
- Investopedia
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