What is a Covered Call? A covered call is an options trading strategy where an investor holds a stock and sells a call option on the same stock to generate additional income. The premium received from selling the call option provides extra income while holding the stock. This method is often used when you expect minimal price movement in the underlying stock. So, what is a covered call? It is essentially a way to enhance returns on your stock holdings.
Key Takeaways
- The covered call strategy involves selling call options on stocks you already own, allowing you to generate income while potentially capping upside gains.
- Successful execution of covered calls requires owning at least 100 shares of the underlying stock, selecting appropriate strike prices, and continuous monitoring of market conditions.
- While covered calls can enhance portfolio yield and provide downside protection, they also come with risks like limited profit potential and the possibility of losing stock ownership if options are exercised.
Understanding the Covered Call Strategy
The covered call strategy is a unique options trading strategy that allows you to generate income by selling call options on stocks you already own. Essentially, it involves owning a stock and simultaneously selling a call option on that stock, creating a short call position. This strategy consists of two components: holding the underlying investment and selling the call option, which gives another investor the right to buy your stock at a predetermined price.
Investors often use covered calls to generate extra income on a security that is not expected to appreciate significantly. By selling the call option, the investor receives a premium, which can serve as additional income while holding the stock. This strategy is particularly appealing to experienced investors who understand its implications and risks and are looking for ways to enhance their portfolio yield.
The covered call strategy works best in a market where stock prices are relatively stable, with minor increases or decreases. It is an excellent choice if you want to generate income while holding your stock for the long term, as it provides a way to profit from anticipated price rises by selling securities at a pre-arranged price.
Implementing this strategy can effectively help you achieve your investment objectives. However, as with all investments, it’s important to remember that it involves risk, a point consistently highlighted by investment advice.
Mechanics of a Covered Call
Executing a covered call requires you to own at least 100 shares of the underlying stock. The process begins by writing (selling) call options on the same asset they hold. The aim is to collect premium income while potentially capping the upside gains of the stock as a covered call writer.
The covered call strategy involves several steps: identifying a suitable stock, purchasing it, selecting a call option at an appropriate strike price, and monitoring the position frequently.
- If the stock price stays below the strike price: The call option expires worthless. In this scenario, the seller keeps the entire premium they received and also retains full ownership of their stock.
- If the stock price rises above the strike price: The call option is likely to be exercised. The seller must then sell their stock at the agreed-upon strike price. While their stock is ‘called away,’ they still benefit by keeping the premium, plus any capital gains on the stock up to the strike price (from their original purchase price).
Owning the Underlying Stock
To sell a covered call, you first need to own the stock – at least 100 shares for every call option contract you intend to sell. This is because the “covered” part of the strategy means your obligation (if the option is exercised) is covered by the shares you already possess. If the buyer decides to exercise their right to buy the stock, your ownership allows you to deliver those shares as per the contract terms.
Selling the Call Option
When selling a call option, you sell your shares at a predetermined price, known as the strike price. This action typically involves only a short call order ticket, making it a straightforward component of the covered call strategy. However, selling the call means that capital gains from holding the stock will be capped at the strike price, which is a consideration for the call option seller.
If the stock price exceeds the strike price, the call option may be exercised, obligating the seller to part with their shares. Investors must be prepared for this possibility and understand that if the short call options are assigned early or expire in the money, they will be required to sell their shares.
This potential outcome emphasizes the importance of selecting the right strike price and being ready to have the stock called away at that price.
Collecting Premium Income
The payment received for selling a covered call is called a premium. This premium boosts the investor’s income while holding the underlying stock, providing additional income regardless of the stock’s price fluctuations. When you sell a call option at a target price, you can keep the premium received, offering a reliable source of income.
If the stock remains below the strike price at expiration, the call option may expire worthless, allowing the investor to keep both the shares and the premium. This scenario creates a win-win situation where the investor retains ownership of the stock and benefits from the premium income, enhancing overall returns and providing a buffer against potential stock declines.
Example of a Covered Call in Action
Let’s bring the covered call strategy to life with a hypothetical example. Suppose you own 100 shares of TSJ, currently priced at $50 per share. You decide to sell a call option with a strike price of $40, and the premium received from selling this option is $0.75 per share.
If the stock price stays below the strike price at expiration, the call option expires worthless, letting you keep both the shares and the premium. This outcome generates income from the premium while retaining stock ownership, providing a partial return on investment.
The breakeven price for this strategy is calculated by subtracting the premium received from the initial underlying stock price purchase price. In this case, the breakeven price would be $44.25 per share.
By understanding this example, you can better appreciate how the covered call strategy works and how it can be applied to your own investment portfolio.
Potential Benefits of Covered Calls
Selling covered calls can significantly enhance portfolio yield by collecting option premiums. This premium income serves as a partial return on investment even if the stock does not reach the strike price. It allows you to generate income while waiting for their stock to appreciate in value.
Setting a target selling price through the strike price provides a structured exit strategy in the covered call strategy. This can be particularly beneficial for investors who have a specific price in mind at which they are willing to sell their shares. Additionally, the income generated from premiums can soften the blow of any losses experienced with the stock.
Using covered calls can create a scenario for investors to generate additional income while providing some downside protection. The premium received can offset potential losses in a declining market, offering a buffer against declines. This makes covered calls an attractive option for investors looking to manage risk while enhancing their returns.
Risks and Drawbacks of Covered Calls
While the covered call strategy offers several benefits, it also comes with its share of risks. One significant drawback is that using covered calls limits potential gains since profits are capped at the strike price. If the stock price rises significantly, the investor’s gains are limited to the strike price, potentially missing out on substantial profits.
Another risk is the potential loss of stock ownership if a call option is exercised. When this happens, the investor may lose ownership of the underlying stock at the strike price, which could be below the market value. This outcome can be particularly unfavorable if the investor had a long-term view of the stock and anticipated higher future gains, adding to the assignment risk and downside risk.
Active management is required to effectively track stock performance, options’ expiration, and market trends. This need for continuous monitoring can be time-consuming and may not suit all investors. Overall, the risks associated with covered calls include limited upside potential, potential loss of stock ownership, and the need for active management.
Steps to Execute a Covered Call
To execute a covered call strategy, the first step is to open a brokerage account and apply for permission to trade options. This typically involves completing an options application and providing proof of trading knowledge and financial readiness. It’s crucial to choose a brokerage account with low fees, research capabilities, and robust trading functionalities.
Next, use the options chain to research different options contracts at various strike prices and durations. Selling a call option at a specific strike price corresponding to the shares you own is the core of the strategy. The ideal time to sell covered calls is when the underlying asset has a stable to positive long-term outlook.
Covered calls are best suited for a relatively stable market environment. After selling the call option, it’s essential to monitor its expiration date to decide your next steps. Regularly reviewing market conditions and stock price movements is critical to determine whether to roll or close out your option position.
By following these steps, investors can effectively implement the covered call strategy, generating income while managing risk in their investment portfolios.
When to Consider Using Covered Calls
You might find the covered call strategy most effective when your outlook for the underlying stock, or the broader market, is neutral to moderately bullish. This means you anticipate the stock price will likely remain relatively stable, experience slow, steady growth, or perhaps even decline slightly, but you don’t foresee a sharp, rapid surge in its value. In such low-to-moderate volatility environments, where significant upward price movement isn’t your primary expectation, covered calls become an excellent tool. They allow you to generate additional income from option premiums, effectively getting paid while you hold the stock, rather than relying solely on price appreciation for your returns.
You will need to continuously monitor market volatility; higher implied volatility generally means higher premiums, but it also signals greater uncertainty. So you’ll want to adjust your strike prices and expiration dates accordingly to optimize your risk-reward balance. This strategy is particularly beneficial if you’ve identified stocks in your portfolio that you believe are fairly valued or might trade sideways for a while. Instead of just waiting for potential long-term appreciation, you can actively generate cash flow.
When Covered Calls Might Not Be Suitable
There are specific scenarios where covered calls may not align with your objectives, the market conditions affecting your investments, or your personal circumstances. If the market is highly volatile, the risk involved with covered calls can increase for you. This could lead to your options being exercised unexpectedly, potentially resulting in unfavorable outcomes. In such environments, the strategy’s effectiveness can be compromised, and you may need to reassess your use of covered calls.
Additionally, because you need to own 100 shares to execute a covered call, this can mean high upfront costs for you and might limit your ability to diversify. You might need to reconsider this strategy if the market conditions or your personal investment goals do not align with the covered call approach.
Maximizing Profit and Managing Loss
Maximizing profit and managing loss are critical components of any investment strategy, including covered calls. The maximum loss from a covered call is the purchase price of the stock less the premium received. Significant loss in the underlying security’s value can lead to maximum loss, despite the premium providing some offset, which ultimately affects the maximum profit.
While the premium received helps in mitigating losses, you are still exposed to significant losses if the underlying stock’s value declines sharply. Recognize that the obligation to sell shares at the strike price limits the potential upside in a covered call strategy. Therefore, managing the covered call position involves not only maximizing premiums but also carefully monitoring the stock’s performance.
Managing risk effectively might involve buying back the option if the stock begins to decline before the expiration date. This allows you to close the position early and limit further losses.
Strategies for Selling Options
When you sell options, your primary aim is typically to generate income (the premium received) by taking on an obligation. The strategies you employ will depend on your market outlook, risk tolerance, and whether you own the underlying asset.
- Covered Calls: As discussed earlier, this involves selling call options against stock you already own (at least 100 shares per contract). It’s a popular income-generating strategy for neutral to moderately bullish outlooks, as the shares you own “cover” your obligation if the option is exercised.
- Selling Naked Options (Uncovered Options):
- Naked Calls: You sell a call option without owning the underlying stock. This expresses a bearish or neutral view (you believe the stock won’t rise above the strike price). The potential profit is limited to the premium received, but the potential loss is theoretically unlimited if the stock price rises significantly. This is a high-risk strategy.
- Naked Puts: You sell a put option without shorting the underlying stock. This expresses a bullish or neutral view (you believe the stock won’t fall below the strike price, or you’re willing to buy it at that price). The profit is limited to the premium, while the maximum loss can be substantial (if the stock goes to zero, minus the premium received). Many investors sell naked puts on stocks they wouldn’t mind owning at the strike price.
Successfully selling options requires more than just picking a strategy; it means understanding the risk/reward profile of each and aligning it with your market thesis. Diversifying across different underlying assets or even strategies (if appropriate for your experience level) can be beneficial, but always prioritize understanding the risks before entering a trade.
Beyond the basic strategy, several factors are critical to your success when selling options:
Selecting the Strike Price:
Choosing the right strike price is a crucial balancing act. It directly impacts the premium you’ll receive and the probability of the option being exercised.
- Out-of-the-Money (OTM) Options: These have strike prices that are currently unfavorable to the option buyer (e.g., a call strike above the current stock price, or a put strike below). Selling OTM options generally yields lower premiums because there’s a lower probability of them being exercised. You’d choose these if you have a strong conviction the stock won’t reach that strike.
- At-the-Money (ATM) Options: Strike prices are very close to the current stock price. These typically offer a moderate premium and a reasonable chance of being exercised.
- In-the-Money (ITM) Options: These have strike prices that are already favorable to the buyer (e.g., a call strike below the current stock price). Selling ITM options yields higher premiums but also comes with a higher probability of being exercised. You might sell an ITM covered call if you’re quite willing to sell your shares at that strike plus the premium.
Your decision on the strike price should be heavily influenced by your expectation of the stock’s future price movement and how much premium you aim to collect versus the likelihood of assignment.
Determining Expiration Dates:
The expiration date defines the lifespan of the option and significantly impacts its premium, largely due to “time decay” (theta).
- Shorter-Dated Options (e.g., weekly, monthly):
- Time decay is more rapid, which benefits you as a seller (the option loses value faster if the stock price doesn’t move adversely).
- Premiums are generally lower.
- Require more active management as expirations approach frequently.
- Longer-Dated Options (e.g., several months out, LEAPS):
- Premiums collected are higher upfront.
- Time decay is slower initially.
- Gives the underlying stock more time to move, which can be a risk or an advantage depending on your strategy.
Also, be aware of option styles: American-style options can be exercised by the buyer at any time up to expiration, posing an early assignment risk for you. European-style options can only be exercised on the expiration date itself. Most equity options are American-style. The “time value” component of an option’s premium (premium minus intrinsic value) erodes as expiration approaches, which is generally favorable for option sellers.
Risk Management Techniques:
Selling options, especially uncovered ones, involves significant risk. Effective risk management is not just advisable; it’s essential.
- Position Sizing: Never allocate too much of your capital to a single options trade or underlying asset. Determine a maximum acceptable loss per trade relative to your portfolio size.
- Understand Your Maximum Risk: For covered calls, your risk is the potential decline in the stock’s value (offset by the premium). For naked calls, the risk is theoretically unlimited. For naked puts, the risk is the strike price (times 100 shares) minus the premium, if the stock goes to zero.
- Strategic Diversification: Don’t concentrate all your option selling on one stock or sector.
- Setting Profit Targets and Exit Plans: Decide beforehand how much profit you’re aiming for on a short option (you don’t always have to hold until expiration) or at what point you’ll cut losses or adjust a trade that’s moving against you (e.g., “rolling” the option to a different strike or expiration).
- Regular Monitoring: Market conditions and stock prices change. Keep an eye on your positions and be prepared to act if your initial thesis no longer holds or if risk levels become uncomfortable.
By carefully considering these elements and consistently applying sound risk management, you can navigate the complexities of selling options and work towards your income generation goals more effectively.
Tax Implications of Covered Calls
When you sell covered calls, understanding the tax implications is important. Here’s what you need to know:
When Taxes Are Triggered: Simply selling a covered call doesn’t immediately trigger a tax event. You’ll recognize a gain or loss (and thus a potential tax liability) only when the call option contract is closed (you buy it back), expires worthless, or is assigned (meaning your stock is sold).
Holding Periods and “Qualified” Status: The tax treatment of your gains or losses can be affected by how long you’ve held the underlying stock and whether the call option is “qualified.” For instance, selling certain in-the-money qualified calls can pause the holding period of your stock, which might impact whether your gains are taxed at short-term or long-term capital gains rates. Similarly, to benefit from lower tax rates on dividends, you need to hold stocks for specific periods, and covered call strategies can sometimes interfere with meeting these requirements.
Capital Gains: Profits you make from covered calls (either from the premium if the option expires, or from the stock sale if assigned) are generally treated as capital gains. The tax rate will depend on your holding period for the stock (short-term vs. long-term) and the overall gain.
Because tax rules can be complex and depend on your individual circumstances, make sure to consult with a qualified tax professional. They can provide personalized advice to help you understand your specific tax obligations, ensure you remain compliant, and potentially optimize your tax outcomes when using covered calls.
Practice Selling Options Before Setting Up a Brokerage Account
Before you start selling options with real money, it’s wise to get some practice. Here’s how you can prepare:
- Options-Enabled Brokerage Account: To trade options, including selling covered calls, you’ll need a brokerage account that’s specifically approved for options trading. Brokerages typically require you to demonstrate some trading knowledge and financial readiness before granting this approval.
- Start with an Options Simulator (Paper Trading): The best way to gain experience without any financial risk is by using an options trading simulator, often called “paper trading.” These platforms allow you to apply what you’ve learned about options strategies in a real-time market environment but with virtual money.
- Benefits of Simulators: Using a simulator lets you practice executing trades, observe how option prices react to market movements, and see the potential impact of your decisions without risking actual capital. This helps you build confidence, refine your strategies, and understand the mechanics of order entry and position management. You can also review your simulated transaction history and performance analytics to learn from your “trades,” allowing for growth and improvement before you commit real funds.
Getting started with a real-time options trading simulator is a highly recommended step before you begin live trading. Click here to practice options trading like covered calls, and more!
Summary
In summary, the covered call strategy offers you a compelling way to generate additional income from your stock holdings while also helping to manage some risk. By understanding how covered calls work, their benefits, and the potential risks involved, you can effectively implement this strategy to potentially enhance your portfolio. Covered calls provide a structured approach to generating income, can offer a degree of downside protection, and are often an excellent fit when you expect relatively stable market conditions for your chosen stocks.
As you consider incorporating covered calls into your investment strategy, remember the importance of staying informed, practicing (perhaps with simulators), and consulting with financial or tax professionals when you need guidance. With the right knowledge and a disciplined approach, covered calls can become a valuable tool in working towards your financial goals. Happy trading!
Frequently Asked Questions
What is a covered call?
A covered call is an options trading strategy where, because you own at least 100 shares of a stock, you sell a call option against those shares. This allows you to earn income from the premium you receive for selling the option, potentially enhancing your returns while you hold the underlying asset.
How do I choose the right strike price for a covered call?
When choosing a strike price, you’re balancing your desire for premium income against the potential for further profit if the stock price rises. Generally, a strike price further out-of-the-money (higher than the current stock price) will yield a smaller premium but gives your stock more room to appreciate before it might be called away. A strike price closer to the current stock price will offer a higher premium but increases the likelihood of your shares being sold if the stock price moves up. Consider your outlook for the stock and your income goals.
What are the tax implications of selling covered calls?
Selling covered calls can have various tax implications. Key factors include whether the calls are classified as “qualified,” how long you’ve held the underlying stock, and what happens to the call option at expiration (expires, closed, or assigned). These can affect how your gains or losses are taxed. Because tax situations are personal, it’s essential to consult a tax professional to understand how these factors will affect you specifically.
When is the best time to use the covered call strategy?
You might find the covered call strategy most suitable when you expect the market for your stock to be flat (sideways) or only slightly bullish, generally with low to moderate volatility. In this type of environment, the risk of the stock price making a large, sudden upward move (which would cap your gains) is lower.
What are some risks associated with covered calls?
The main risks with covered calls include:
Underlying Stock Risk: You still own the stock, so if its price falls significantly, the premium received may only partially offset your losses. Active management can help you navigate these potential issues.
Limited Upside Potential: Your profit on the stock is capped at the strike price (plus the premium received) if the stock price rises significantly above it.
Potential Loss of Stock Ownership: If the stock price is above the strike price at expiration, your shares will likely be “called away” (sold). This might be undesirable if you wanted to hold the stock for longer-term appreciation.