Selling covered calls is a tried-and-true strategy for increasing income, reducing volatility, and diversifying both equities and fixed income core strategies.
Selling covered calls is the practice of selling (writing) call options while also owning shares of the underlying stock. Combining options and stock positions can provide investors with distinct investing exposures.
The fundamental appeal of writing covered calls is the ability to generate instant revenue, which can give an alternative strategy of producing yield. A well-managed covered call strategy has the ability to provide good returns, decrease risk, and generate significant extra income.
In practically all market conditions, I believe that investors would be well-served by seriously contemplating the addition of an income-producing covered call strategy. This article will explain how covered calls function and when to utilize them in detail.
What are Call Options?
On listed stocks, there are only two types of options securities: put options and call options.
A put option is a type of option contract that grants the buyer the right, but not the obligation, to sell the underlying securities at a certain price (also referred as the strike price) prior or on a set expiration date.
Being an option seller (in this case a put option writer) doesn’t carry additional risk in comparison to owning a long stock position, as the maximum loss for a short put option position is the same as owning the shares of the underlying security acquired at the exercise price (the specific strike price), and happens only when the market price of the stock drops to zero.
On the other hand, call options give the call buyer (holder) the right to buy shares of an underlying stock at a predetermined price (known as the strike price, or exercise price) until the expiration date, whereas put options give the holder the right to sell shares of an underlying stock at the strike price before the expiration date.
Call options are financial derivatives that allow a buyer the right, but not the obligation, to acquire an asset at the strike price before it expires. If the buyer chooses to exercise the option, the seller of the call option must sell the securities at the strike price.
Options do not generate value; rather, they transfer value from one party to another. They may be used for a range of tactics, including placing leveraged trades on assets, risk management, and income generation. The premium (the price of the option paid by the buyer), is impacted by the strike price, the amount of volatility, the option’s time to expiration, and the price of the underlying asset.
Because their value is linked to the value of a distinct underlying security, options are categorized as derivatives. That is, they can be used alone to speculate on the direction of that asset, or they can be used in conjunction with their underlying securities to give benefits such as extra income, which would reduce the magnitude of the loss if the stock price fell. A well-established strategy that combines a long stock position with the sale of call options on that stock provides these rewards.
What is a Covered Call Strategy?
A covered call strategy is an option-based income strategy that tries to receive income from option sales while also minimizing the risk of writing a call option without owning the underlying asset.
A covered call consists of an investor both:
- holding at least 100 shares of a stock
- selling a call option contract for every 100 shares owned of that stock
A covered call strategy consists of owning stock in a publicly listed business while selling (or writing) call options on the same assets. Call options provide the option buyer the right to acquire the stock at a fixed “strike price” within a certain time frame. On the other hand, selling call options generates revenue that may be dispersed or reinvested in the portfolio. The income might be reinvested to help offset losses in a market fall or used as a source of yield for the investor.
Because call options give their holders the right to buy the underlying stock at the designated strike price at any time before expiration, regardless of where it trades in the market, sellers of call options assume the obligation to sell the stock to the buyer at that strike price if the buyer chooses to exercise the option. The seller is compensated by the buyer (the option premium) for accepting that responsibility and restricting their upside potential in the stock for the life of the option.
Those who sell calls without owning the underlying stock (“uncovered call” sellers) are essentially exposing themselves to unlimited upside risk, as they would be required to deliver the stock if the option is exercised, which could mean having to purchase it at a sky-high price to meet that obligation. Brokers restrict who is permitted to sell uncovered calls and, as a result, impose significant margin requirements as collateral.
Those who sell calls and possess the underlying shares, on the other hand, are “covered” in the sense that they may simply deliver the shares they hold to fulfill an exercise obligation. As a result, covered call sellers (writers) are in a significantly safer situation than uncovered call sellers.
The covered call writer assures that they can satisfy the obligation of an option exercise by holding the underlying shares, regardless of the price of the stock. There is no longer an infinite upside risk, and covered call writers are not obliged to use margin, as long as they do not sell more than one option contract for every 100 shares held.
Covered call writing is thus an investing technique that combines stock ownership with the sale of covered calls. The covered call writer is paid a premium by the call option buyer in exchange for the commitment to sell the stock at the strike price at any time before the option expires. In this sense, the covered call writer has effectively exchanged part of the stock’s potential gain for a set return in the form of an option premium.
Covered call writers face an opportunity risk on the upside (the risk that the stock will rise and they will not fully participate in that gain), but because covered call writing requires money for that obligation, it actually offsets downside losses if the stock price falls and produces a fixed return for the period. Covered call writing tactics have been used by institutional investors for decades for these reasons.
Example of a Covered Call Trade
The strike price, expiration date, and underlying securities of a call option contract are used to identify it.
Covered Call Option Contract
- Jeff owns 100 shares of ABC stock at a current price of $100 a share and believes the stock’s price will not move over $110 in the next 30 days.
- Steve believes that stock ABC will climb over $110 and hence purchases a call option.
- Steve buys a call option contract from Jeff for a $5 premium per share with a strike price of $110 and an expiration date of 30 days.
Potential Outcomes Upon Contract Expiration
#1 – ABC stock price is $125 (above the strike price)
Jeff is obligated to sell the stock for $110, which is less than the market price, but the contract provides for a $500 premium ($5 per share x 100 shares).
Even though the stock is now selling at $125, Steve has the option to acquire ABC at $110. The profit for Steve is equal to the open market stock price ($125) less the strike price ($110) plus the option premium paid to establish the contract ($5), resulting in a profit of $10 per share.
#2 – ABC stock price is $115 (above the strike price)
Jeff is obligated to sell the stock for $110, which is less than the market price, but the contract provides for a $500 premium ($5 per share x 100 shares).
Even though the stock is now trading at $115, Steve has the option to acquire ABC at $110. The profit for Steve is equal to the open market stock price ($115) less the strike price ($110) plus the option premium paid to establish the contract ($5), resulting in a profit of $0 per share.
#3 – ABC stock price is $110 (equal to the strike price)
The contract pays Jeff a $500 premium ($5 per share x 100 shares) regardless of Steve’s choice to buy stock ABC from him.
For Steve, there is no difference between acquiring stock XYZ from Jeff and just declining the option. In both circumstances, Steve loses the $5 per share premium paid to Jeff when the contract was established.
#4 – ABC stock price is $105 (below the strike price)
Jeff keeps the contract’s stock ABC as well as the $500 premium ($5 per share x 100 shares).
Steve sees no need to pay more than the market price of $115 for the shares. Steve looses the $5 per share premium paid to Jeff when the contract was established.
The word ‘covered’ refers to the fact that if the stock price rises, the option may become ‘in the money,’ which is a negative for the option seller; but, because the seller also owns the underlying stock, the profits on the equity position offset the option losses.
Another way to look at it is that the investor foregoes the potential upside of their stock position in return for the premiums received from selling call options on that position.
Why Use a Covered Call Strategy?
A covered call is a popular entry point into option trading for many investors. There are certain risks, but they are mostly associated with holding the stock rather than selling the call. The selling of the option just reduces upside potential.
When you sell a covered call, you profit from the time decay of the options you sold. Every day that the stock does not move, the value of the call you sold decreases, benefiting you as the seller.
Your stock will not be called away as long as the stock price does not hit the strike price. In principle, you can keep repeating this method on the same piece of stock indefinitely. And with each covered call you execute, you’ll have a better understanding of how the option market works.
If you already hold a stock (or an ETF), you may increase your income and overall returns by selling covered calls on it. Income from covered call premiums can be 2-3 times as high as dividends from that company, plus you get to keep getting dividends and some capital appreciation.
Covered call strategies, by definition, sacrifice upside in exchange for present income. As a result, covered call techniques can be utilized strategically in income-focused portfolios or tactically by investors who feel the markets are unlikely to climb further.
Selling covered calls entails receiving a sum of money in return for holding a stock and being compelled to sell it at a set price if it becomes overvalued. Even in a flat or negative market, this will limit your upside but create substantial profits in the meanwhile.
Covered call strategies can play a particularly important role in income-oriented portfolios in the present market scenario, where income is scarce. With global rates at record lows, conventional income-generating instruments such as bonds are falling short of investor expectations. Covered call techniques can generate significant income while diversifying a portfolio’s risk sources.
Which are the Best Market Environments for a Covered Call Strategy?
Several peer-reviewed research imply that a covered call strategy outperforms the S&P 500 Index over longer time periods while having a smaller standard deviation of returns.
The return profile of a covered call strategy is tempting, but investors should be mindful that performance may vary depending on market conditions. Below, I explain how investors in covered call strategies might anticipate to fare in various market scenarios.
Bull Market
In continuously or quickly rising markets, the covered call strategy tends to underperform since most of the gain on underlying assets is capped by the stocks being called away at strike prices lower than the growing market price. Because an investor keeps the option premium but foregoes part or all of the upside, he or she will most likely underperform the market. In this context, income earned by selling covered calls often accounts for the majority of profits, complemented by minimal capital gains on the underlying equities.
Flat Market
In a flat market, a covered call strategy can be a potent alternative approach for performance. As the markets remain stagnant, the investor will likely outperform, but the premium from selling the call option will be retained. For example, writing calls with an out-of-the-money strike price (e.g., $105 on a $100 stock) provides for capital appreciation while receiving the call premium. Long periods of flat returns in the equities market have occurred in the past, and these are the times when a covered call allocation may be a substantial source of value-added returns.
Bear Market
Long-term investors are expected to outperform since the premium obtained from selling the call option balances part of the stock’s loss, providing downside protection. Covered call writing tends to outperform in sideways and down market settings because to the considerable revenue gained from selling calls as well as dividend income from the underlying companies. In this scenario, the options are more likely to expire worthless (out of the money), leaving the portfolio owning the stock as well as the premium income. While a sharp market downturn, such as the one that occurred in 2008, might result in a negative total return in a covered portfolio, its performance should outperform that of its underlying assets by roughly the amount of the premiums (minus expenses).
Which are the Best Conditions for a Covered Call Strategy?
Covered calls are a handy instrument that, in the hands of a wise investor, may be extremely rewarding in the proper conditions. They can be an interesting alternative to a standard buy-and-hold strategy at times like these.
1) During periods of market overvaluation, when the market is expected to be flat or down for an extended length of time. Even in a lengthy bad market, you may earn good money via options and dividends.
2) For slow growth firms, you may optimize your returns by combining dividends, call premiums, and capital appreciation via share purchases and sluggish organic growth.
3) When one of your stock assets becomes overpriced in comparison to its fair worth. Rather of waiting until it’s overpriced to decide whether or not to sell it, you may start producing extra income and returns from it now by selling covered calls at strike prices that are far higher than the fair value estimate for your stock. If it eventually rises beyond your strike price, requiring you to sell, you can reallocate that cash to other discounted investments.
What are the Main Variables in a Covered Call Strategy?
There are several approaches to implementing a covered call strategy, but three of them are perhaps the most significant.
Underlying Assets
What are the strategy’s underlying securities? More volatile assets can earn higher premiums, but they also have a higher downside risk. The premium might fluctuate based on the security, the stock’s price history, and the market climate.
A volatile stock will almost certainly provide greater call prices, and total call premiums will grow as market volatility rises. The Chicago Board Options Exchange Market Volatility Index (VIX), which measures the implied volatility of S&P 500 index options, is a common way to assess this trend.
Consider working with stocks that have options with a medium implied volatility, as they should provide enough premium to make the trade worthwhile.
Coverage Percentage
Is the strategy going to write a call option equal to the full portfolio’s value, or only a portion of it?
- A portfolio that is entirely covered optimizes premium income while sacrificing all potential.
- A portfolio that is 50% covered receives half of the premium income but only receives half of the upside from the underlying stocks.
Moneyness of the Options
The further out of the money the call options are written, the bigger the upside potential, but the smaller the premiums.
How to Sell Covered Calls
The technique for selling covered calls presupposes the investor has a brokerage account with options approvals and a minimum of $2,000 in equity. Most brokerage firms provide covered call writing in cash or margin accounts, as well as IRAs.
To begin, the investor owns (or purchases) 100 shares of a stock. The investor then sells a call option contract that covers those shares at the selected strike price and expiration date. Because the investor is selling an option, their position is referred to as “short” rather than “long.”
The option seller may select any strike price or expiration date that is appropriate for their strategy and forecast for the stock. In general, selling higher strike calls generates less option premium while allowing the stock to rise more before hitting the strike price and being called away.
Selling calls with lower strike prices, on the other hand, generates more revenue but raises the chance of losing the stock due to an exercise. Investors must decide how much potential upside growth they are prepared to forfeit in exchange for a set return throughout the time.
The option writer must also decide on an option expiration date. The further the expiry date, the more premium a call writer will earn, but the longer they will be compelled to sell the stock at the strike price.
Furthermore, time value in option premiums is not connected to time in a linear sense. That is, going out twice as far into the future produces less than twice the option premium. When expiration approaches the time value contained inside the option prices will go to zero, leaving only intrinsic value.
Pros of Covered Calls
- Earn extra money from the stocks you own. When you sell a covered call, the buyer will give you a premium. If you want to generate revenue from your portfolio, this approach can help you do so every time you sell a call.
- Assist you in determining a target selling price for your stock. Using covered calls, you may set a selling price that is greater than the current market price.
- When compared to other riskier options trading strategies, losses are limited. Even in the worst-case scenario, if the stock falls to zero and the shares become worthless, the loss is limited, unlike other options methods, which might expose investors to unlimited losses.
Cons of Covered Calls
- Limit your potential gains from future stock price increases. When selling a covered call, you can earn the premium plus the difference between the strike price and the current price per share. If the price of that share rises over the strike price, you must still sell the shares at the strike price.
- You must keep the stock until your options expire. When your intentions change, you may decide to sell part of your investments. To keep a call covered, you must own the shares until the option expires, which may necessitate holding the shares for a longer period of time than planned.
- Capital gains taxes apply to net gains. Based on a variety of criteria, you may be required to pay short-term or long-term capital gains taxes.
Keys Takeaways
- Covered calls allow you to create additional revenue from a stock portfolio.
- Because you own the shares involved in the option, covered calls are low-risk.
- In the worst-case scenario, you miss out on possible gains over the call contract’s strike price.
- Covered calls may be the greatest option for long-term investors who buy shares of reliable companies.
- Covered call net gains may be liable to capital gains tax. Covered call writing, like any other trade, has tax implications.
- Before making a decision, consider your long-term holdings and investing goals.
Conclusions
Covered call selling is a popular investment strategy that combines stock ownership with the sale of call options on certain stocks.
The technique, which may be executed in a variety of ways to meet an investor’s holdings, risk tolerance, and objectives, provides distinct benefits such as producing income, reducing stock price volatility, and hedging downside risks. In exchange, covered call writers agree to sell their shares at the price specified by the option, which means they give up some of the upside potential in the stock(s) on which they’ve written call options if they’re required to deliver their stock to another party as a result of an option exercise.
For investors willing to understand and execute covered call writing in their portfolios, the large range of listed options available on many equities enables several ways to profit from the approach. For example, a covered call position on the shares of the underlying stock you already own could be a great way to generate additional income and edge the portfolio over value when the stock price drops.
Selling covered calls, like any tool, may be extremely valuable in the right hands at the right moment, but it can also be worthless or detrimental when used poorly. Selling covered call options is an effective technique, but only under the appropriate circumstances.