You might gravitate toward traditional investments, holding onto them until they reach higher returns, then selling them for a profit. But did you know that you can sell covered calls against stock you already own? Options trading offers you a potential opportunity while you invest in traditional investments.
Writing covered calls is one way you can take your investments a step further while still 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.
What is a covered call?
What are "covered calls," exactly? A covered call means you sell call options against stock you already own or have bought. You give the buyer of the call option the right to buy the underlying shares at a specific price (called the strike price) and within a specific timeframe. It's "covered" because you already own the stock sold to the buyer of the call option when they exercise it.
Since a single option contract usually represents 100 shares, you must 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, an experienced investor considers the covered calls options strategy if they plan to hold on to a stock but don't anticipate a price increase in the near future. Writing covered calls allows you to potentially make income through the premium while holding 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 deliver stock you already own.
How does a covered call strategy work?
If you were to embark on a covered call strategy, here’s what you would generally do:
The first step is purchasing stock shares with a brokerage, such as Ally Invest, preferably choosing stable, non-volatile stocks. Next, you’d sell call options against the stock that you've purchased. One option contract usually represents 100 shares, so you must own at least 100 shares for every call contract you plan to sell.
It’s important to pick a strike price at which you'd feel comfortable selling the stock. Consider a strike price that’s out-of-the-money (those that would generate a loss if exercised) — this is because you generally want to see the stock rise further in price before having to part with it.
Next, you’d pick an expiration date, typically a date about 30 to 45 days in the future, or an acceptable premium for selling the call option at the strike price you choose. (The further away the date, the more difficult it may be to predict what will happen, but it's more likely that you'll make more as you move forward in time.)
At expiration, one of two things will happen:
Expires "in the money": If the stock finishes above the call's strike price, it's called "in the money," and the call buyer buys the stock from you at the strike price. The call seller keeps the option premium. (When you sell the option, the buyer pays you a premium as income from selling the option.)
Expires "out of the money": If the stock finishes below the call's strike price, the call seller keeps the stock and the option premium. The buyer's option expires worthless.
Note that you also have the opportunity to execute a buy-write, which entails buying stock and selling the call option in one transaction. Not only might buy-writes be more convenient, but they also limit the possibility of market changes occurring between your buying and selling transactions. A buy-write means executing a multi-leg position in one transaction — helpful to avoid legging into the trade.
What is assignment?
When you write covered calls, in exchange for the option premium, you accept an obligation to provide 100 shares 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.
You never know when you'll be assigned, but if the buyer of an option chooses to exercise their option, the Options Clearing Corporation receives an exercise notice, which begins the assignment process.
Assignment is random, and if you have a short options position, you may be assigned by your brokerage firm.
It can certainly come as a surprise when called to deliver stock — but try not to panic. If you are concerned about 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.
Remember that this isn't your only choice if you are assigned. You could also not even deliver any of the stock you currently own.
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. It's also a good idea to consult a tax professional before making decisions like these.
Covered call example
Let's take a look at a hypothetical covered call example:
Sarah owns 100 shares of ABC stock. Each share trades at $50 per share, so she owns $5,000 worth of ABC stock. Sarah decides there's no chance of ABC stock going up in price anytime soon, so she decides on selling covered calls on the stock she purchased to earn more on her original investment.
Sarah sells one call option with a strike price of $50 and an expiration date one month from today for a premium of $2 per share. In other words, Sarah will pocket $200 ($2 x 100 shares) in exchange for agreeing to sell to an option buyer at $50 per share if the buyer exercises the option.
If the price of the stock stays below $50, the option buyer will not exercise the option, and Sarah will keep the $200 premium. But what happens if the price of the stock goes above $50?
In this case, the option buyer will likely exercise the option, and Sarah will have to sell her shares of ABC. Since Sarah's profit from the option premium was $200, her total profit from the sale would be $5,200 ($5,000 + $200).
What are the risks and possible rewards in taking on a covered call strategy?
Like any investment strategy, covered calls have risks and rewards. Review the pros and cons of a covered call strategy before you take advantage of this investment strategy.
Advantages of covered calls
First, the advantages of covered calls:
Make money on underperforming stock: 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.
Limit risk: 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. When writing covered calls, one way to do that is using a buy-write strategy.
Increase your investment income and hold a long stock position: Whoever said you couldn't do two things at once? Writing covered calls allows you to increase your investment income while still holding your long stock position. Like all trading, this options strategy entails risk. Understanding the implied volatility of your underlying shares to reduce downside risk and having a plan in place (should your stocks be assigned) can help boost your options game.
Risks of covered calls
Now, the risks of covered calls:
Can lose money: As a stockholder, your underlying stock may lose value — and the downside risk means your loss could outweigh the gain from the option premium. You could increase your losses if the stock price drops, and you want to sell your position. You may escalate further losses if you need to repurchase your call options. Review options trading mistakes you can make before you get started.
Limit profit potential: It's important to realize that covered calls also limit your profit potential, as your shares will likely be 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.
Tax implications: Keep the tax implications of executing this kind of trade in mind — you may want to speak to a tax advisor before writing covered calls.
When would an investor use a covered call?
Here are a couple situations in which you might consider a covered call:
If you don't anticipate a price increase in a stock you've purchased and are not emotionally attached to the stock.
If you want to tap into one of the least risky option trading strategies — however, it's essential to make sure you choose appropriate stocks for covered calls because not all stocks fit the bill as an eligible covered call option.
Now that you've gotten covered calls explained, is it the right strategy for you? Take all these ins and outs of writing covered calls into consideration as you decide whether this options strategy fits your investing goals.