Covered Call
An options strategy used by large investors and professional market players to boost investment income.
A covered call is an options strategy used by large investors and professional market players to boost investment income. However, with an understanding of the process, individual investors can also participate in it.
This options strategy is technically a short-term neutral or bearish position over a long-term holding for investors.
Investors who already own shares of a certain stock may write (sell) call options for short. These shares are sold as a contract to someone who believes the stock will rise.
Investors can generate cash (premiums) from selling the contracts in the present when they do not believe the stock has much upward momentum.
There are limited profits to be made, but if done correctly, they can add up in the long game.
While this strategy may limit the upside potential, investors can still make small gains that add up quickly.
Writing options is a great way to add income through your investments. Generally, an investor could make 1% - 5% back on their investment by selling covered calls. If they do this every week or month, they could add money to their investments yearly.
This method could help individuals who do not have much money to invest past their investment levels. On the other hand, if someone needs extra monthly money, they could use their investments as income to buy everyday necessities.
There are a few things that we will talk about further down on the tax side of the equation since you could be dealing with massive capital gains when you sell the underlying stock.
Although there are different ways to find the best stocks to sell options, writing options should not be the only reason to buy shares in a company; this could put an investor at risk of selling the shares at a loss. Also, the premium would not be able to recuperate the lost capital.
How to Understand Covered Calls
Options can be sold by investors who own one hundred or more shares of a stock - the direction of this strategy is neutral or bearish. This allows investors to hedge their positions in the short term while still being bullish in the long term.
If the stock price is above the strike price at the date of the contract’s expiration, then the investor is obligated to sell the shares to the option’s buyer at the specified strike price if they decide to exercise those shares.
This strategy is great for investors who plan to hold for ten or more years, but on the other hand, this may not be a great strategy for those who are position trading and see the stock as overvalued or bearish.
Therefore, they should sell the stock because the premiums will not compensate for the losses incurred.
An investor would be willing to sell options because they would be generating income through premium payments. Although, investors should only be writing options if they feel the underlying stock will not move significantly.
Investors can ensure that their underlying stock has little upside potential through market analysis, sector analysis, or special events that may cause a downward movement.
Another thing to note is that investors should not be worried about downward movement in stock if they plan on holding it for a long period. Also, generating income from premiums is a great way to buy more shares at a low price for long-term buying and holding positions.
How Profitable Are these Calls?
This options strategy can be highly profitable if done correctly, but like any trading and investing process, inherited risks are involved. The best thing that can happen for an investor is if the stock price rises to the highest price without exceeding the strike price.
This will allow them to collect the overall profit of the stock once the contract expires, as they also collect the premium from writing the option.
Selling options can be very profitable in the long term depending on the average price of an individual's stock and the premium they receive from selling a contract. Therefore, if you plan on holding a certain stock, it may be worthwhile to sell options when the time is right.
Assuming, for instance, an investor is selling options on a dividend stock, those premiums and dividends could add up nicely in the long haul; writing covered calls can increase your income and help you reinvest those premiums in other places.
You do not necessarily have to reinvest the money into other investments; you could also use the income from the premiums to pay for personal usage such as groceries, save up for a family vacation, or fuel.
How Much Risk Is Involved?
Writing options is a comparatively low-risk strategy considering other options strategies. It only depends on when you decide to sell them, which identifies how risky it could be. For example, you should never sell these calls during your specific holding earnings reports.
I can write two contracts if I own two-hundred shares of Apple Inc. Let us say the stock is trading at $163.67, but there is an earnings report in 3 days. An investor should refrain from selling options during this time.
Although once earnings have been reported, you could potentially execute the strategy. For instance, if AAPL misses its earnings and drops $18.00, one could sell two out-of-the-money call options. Selling out of the money, while a smaller premium would help ensure profit.
Another example of when an investor should not write options is during bullish momentum. Instead, someone should sell options only during a neutral or bearish pattern.
The only other risk of selling options is if the stock price declines to a point where your position is no longer profitable. For example, if you have to hold a stock that is no longer profitable because you sold a contract, you may have to sell those shares if you wish to cut the losses.
Low risk is associated with these calls if you plan to hold the stock position for longer. This is because you cannot incur a loss on stock equity unless you sell it for a loss. Thus making covered calls is a great investment strategy.
What Are The Advantages?
Writing options have two main advantages: income from premiums in neutral or bullish markets and slight protection against your positions in bearish markets.
Creating income through selling options can be a great way to boost your account. Even more so, if those shares are producing income from dividends, this will allow you to buy more shares of that stock or push it into other investments or trades.
This options strategy also allows investors to slightly protect their assets in a way where an investor picks a strike price far away from what the stock is currently being traded at and an expiration date where the stock will likely not reach the strike by then.
Although in rare cases, an individual may still make a profit despite the stock reaching the strike by selling those shares at the designated strike price. This happens when your average price per share is lower than the strike of the contract sold.
Another advantage to writing options is that if you own a dividend stock and sell an option for the underlying stock during the period when a dividend is going to be paid, you do not have to worry about not earning the dividend because it is already priced into the premium received.
These premiums can become very profitable as time passes, especially if you buy high-quality stocks, indexes, and ETFs. Some great equities to consider are Microsoft, Apple, SPY (S&P 500 Index ETF), and UPS (United Parcel Service).
What Are The Disadvantages?
The main disadvantage of writing options is that the profits to be made are capped; the only way to make money on covered calls is if the stock remains below the designated strike. On the other hand, this will allow you to take all of the premia.
There are few times when your premium will cover the cost of the shares lost, resulting in a profit even when obligated to sell your shares.
In all other cases, you will be at least giving up your shares or even giving up both; the premium (from selling your stock at a loss) and your shares.
Another disadvantage is when there is a bullish run in your position. This can result in you losing your shares while also missing out on an opportunity to sell your shares at a profit.
The only other disadvantage is when you get in a stock position you do not intend to hold for a long period, and the stock declines rapidly. Then, although you may be getting a premium for those contracts, you might have to sell those shares at a loss.
This could be a great reason not to get into a position around earnings or a large economic announcement. These events greatly affect stocks and could affect your ability to make money.
Different Covered Call Strategies
A few different options strategies can be used depending on the amount of risk the investor is willing to take on.
1. When you sell a contract in a very volatile stock
These stocks will have better premiums, but only because the risk is much higher because of the volatility.
2. When you write options for 100% of your portfolio
While this may maximize the entire profit, you also risk the ability to capitalize on a bullish move and risk losing your shares if the contract expires above the strike.
3. Writing options that are far out of the money
The premiums from these contracts will be lower because of the higher chance that the contracts will hit the expiration date with no value.
These strategies are not meant for every investor. Deciding which strategy one wants to use would depend on how long one plans to hold the stock.
For example, if an investor or trader is position trading, and they think that the setup is bullish over a three-month period, the investor may sell an option contract with an out-of-the-money (OTM) contract.
The investor may be risking their shares over months, but they are also collecting cash if they were to expire worthlessly. Although they think the stock is bullish, they do not expect it to hit their selling target until three months later.
If you are planning on holding your contracts for a long period, you might want to consider using the strategy where you use your entire portfolio to write options.
This will allow you to create maximum profit on those shares, and you can reinvest those premiums.
Despite great payoffs from selling options on volatile stocks, it can still be risky. Hence, investors should be more thorough in their research if they consider selling options on such equities.
What Does All of This Mean?
Writing covered calls is a great way to increase your investment accounts over some time. In addition, there is no limit on who can sell options as long as you own one-hundred shares of a company with options trading available.
It occurs when you sell your shares in an option contract to a buyer and is considered a bearish or neutral strategy where you do not think the stock price will go above the designated strike price.
For a normal investor, covered calls can truly grow their investments in a big way where it could, increase their portfolio by 1%-5% every month. As a result, they can also roll the income from the premiums to other investments.
There are risks involved in this strategy; you could potentially lose your shares if the option buyer decides to exercise his right when the stock reaches the strike. Nevertheless, you can also lose those shares if the strike is below your average cost basis in that position.
Although the risk is there, it is unlikely to affect you if you understand what you are doing. Understanding when to sell options is the most important part of this strategy; an investor should not be doing this during earnings calls and large economic events that could fluctuate the stock price largely.
Lastly, if you have evaluated the stock and do not believe that it is likely to go any higher and plan on holding your positions for a very long period, then there is no reason that you should not be selling covered calls.
The longer you hold a position and sell options responsibly, the sooner you could have a green future in front of you. There is virtually no risk added, and much profit can be seen in the long run.
Yes, these calls can protect your shares while creating income from premiums. It is worth it if you plan to hold your shares for years since writing options can be considered dividends on steroids.
Yes, there is some inherited risk of covered calls. These include risking selling your shares at the designated strike and losing the premium you were given when you sold off the call contract.
Yes, if you can, and it is reasonable, you should let the call options expire. Unless in cases where you would need to free some capital for another position or the trade is not progressing in your favor, then you can sell the shares before the expiration.
Two specific possibilities could go wrong; the first is that the stock price goes below the average price of the shares you own, resulting in a loss if you sell the stock.
The other is if the stock goes above the strike, there is a chance you can lose your shares. If you write an option where the strike is below your average share cost, you could also be selling those shares at a loss.
Contracts normally expire every third Thursday of every month. Weekly contracts are the same, although they start each Thursday and expire eight days later.
Researched and authored by Adam Bridges
Reviewed and edited by Ayah Murshidi | LinkedIn
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