Are you looking to elevate your investment strategy? Writing covered calls could be a way to add investment income to your portfolio, while holding on to your long stock positions. You don’t have to be an investment professional to take advantage of this options move — but it won’t hurt to learn the ins and outs of a covered call strategy before adding it to your options playbook.
First: The Basics of Covered Calls
A covered call is a popular income-producing options strategy that involves selling or writing call options against shares of stock that you already own. That means when you write a covered call, you are selling someone else the right to purchase stock that you already own, at a specific price (called the strike price) and within a specific time frame.
Since a single option contract usually represents 100 shares, you have to own at least that amount (or more) for every call contract you plan to sell to utilize this strategy.
Wondering why you would write covered calls? Typically, a covered calls options strategy is employed by investors who plan to hold their stock for the long term, but don’t anticipate a price increase in the near future. Writing covered calls allows you to make income through the premium while you hold on to the stock, because as a result of selling (a.k.a writing) the call, you pocket the premium right off the bat.
And the fact that you already own the stock means you’re covered — hence the name — if the stock price of the underlying shares rises past the strike price and the call options are assigned. You simply deliver stock you already own.
A Step Further: What is Assignment?
When you write covered calls, in exchange for the option premium, you accept an obligation to provide 100 shares of the stock for each option contract, should the stock price reach the strike price. But you’ll only be asked to honor this obligation if the call options are assigned.
If an options buyer chooses to exercise their option, the Options Clearing Corporation receives an exercise notice, which begins the process of assignment. Assignment is random, and if you have a short options position, you may be assigned by your brokerage firm. Learn more about how the assignment process works.
Tip: To maximize your premium income while still limiting your chances of having your stocks called away, consider working with stocks that have options with medium implied volatility.
So, you’ve been assigned. What now?
It can certainly come as a surprise if you’re called to deliver stock — but don’t panic. If you are concerned about the tax considerations, you may be able to manage your exposure.
Consider this example. Say you’re worried about triggering a large tax bill from delivering stock. In this scenario, you own 200 shares of a stock called ABC. You bought the first 100 shares 10 years ago, and the second 100 two years ago. That first set of shares was quite a bit cheaper and selling them now would result in significantly more capital gains than selling the second set of shares. The good news is if you’re assigned, you can choose which lot of shares to deliver. In this case you might consider the second set, as you would pay less in capital gains taxes.
Keep in mind that if you are assigned, this isn’t your only choice. You could also not even deliver any of the stock you currently own. Here’s some more insight on what you can do in this situation.
Tip: It’s a good idea to consult a tax professional before making any large decisions of this nature.
Finally, what are the possible risks and rewards in taking on a covered call strategy?
Like any investment strategy, covered calls have risks and rewards. As a stockholder, it’s possible your underlying stock will lose value — and the downside risk means your loss could outweigh the gain from the option premium. And it’s important to realize that covered calls also limit your profit potential, as you will likely have your shares called if they reach the strike price. That means even if the stock price continues to rise, you won’t be able to realize profit beyond the strike price.
When you write covered calls, it’s a good idea to understand both the static and if-called returns, so you know how much of a reward is possible. That requires comparing your return if you write the covered call and the stock doesn’t move, so your profit is the premium (static) versus your return if you are assigned and have to deliver the stock at the strike price (if-called). Take a look at how you can compare these returns.
Covered calls are generally seen as a neutral strategy for investors — meaning you typically wouldn’t write them if you expect a stock price to move drastically up or down. Still, limiting your market risk is usually a good idea when options trading. One way to do that when writing covered calls is using a buy-write strategy. That entails buying stock and selling the call option in one transaction. Not only can buy-writes be more convenient, they also limit the possibility of market changes occurring between your buying and selling transactions. As always, it’s important to keep in mind the tax implications of executing this kind of trade, and you may want to speak to a tax advisor before doing so.
Tip: A buy-write means you’re executing a multi-leg position in one transaction, so you avoid legging into the trade.
Writing covered calls allows you the chance to increase your investment income while still holding your long stock position. Like all trading, this options strategy entails risk. But by understanding the implied volatility of your underlying shares, in order to reduce downside risk, and having a plan in place should your stocks be assigned, you can use this strategy to boost your options game.