Many new investors think options are a way to make leveraged bets. This is usually true for option buyers. But selling options could also be a great way to generate some income and boost your overall stock market returns.
In this article, we’ll review one such strategy: covered call writing. We’ll first define a covered call, then outline how and when to write it, and explore its advantages and risks.
What Is a Covered Call?
Covered call writing is an investment strategy in which you write (i.e., sell) new call options for the stock that you already own. Essentially, the buyer of the option is paying the call writer (you) for the right to buy the underlying asset at the strike price.
When you write an option, you immediately collect the option premium from the buyer. This is income that arrives in your brokerage account and is yours to keep, regardless of what happens next.
Once the option’s expiration date approaches, two scenarios are possible:
- The underlying stock price increases and exceeds the strike price, so the option is in-the-money. It gets assigned, and you must sell your stock for the strike price.
- The price of the stock remains below the strike price, and the option is out-of-the-money and expires worthless.
The shares you own provide a “cover” for the option, guaranteeing that you can deliver the stock if the option is exercised. This is similar to when you write covered puts and keep cash as the guarantee.
Because options are usually written for 100 shares, you’d need to hold at least that amount to write one call option.
If you buy a stock and simultaneously write a call option against that stock, this is known as a buy-write strategy.
Covered Call Writing Example
Let’s imagine you own 100 shares of AstraZeneca (NASDAQ:AZN), and the current market price is $58.75 per share.
You’re happy to hold it for the long term for its healthy dividend yield, but you don’t expect the price to rise much higher, given that it’s already near the stock’s all-time high of $60.93.
Furthermore, if the price would hit $65 over the next six months, you would be willing to sell your shares because you think the company would be too expensive. You decide that covered call writing is the way to go.
For your covered call, you pick $65 as the strike price and December 17, 2021 as the expiration date. This is an out-of-the-money call option so the option premium is relatively low, just $1.10.
Still, this is a decent return, comparable to some dividend yields: $1.10 / $65 = 1.6% in six months or about 3% annualized.
In December, one of two things will happen:
- AZN’s share price is below $65, and you keep your shares while the option expires worthless.
- AZN’s share price is above $65, the strike price of the call, so the option is exercised, and you sell the underlying shares for the strike price.
If the share price continues to go up, you might be wishing you’d kept your stock. Yet that was your target and you’d likely have sold at that price even if you didn’t write the option.
This is it, nothing too complicated. Now let’s see when and how to do this.
How and When to Do Covered Call Writing
In practice, covered call writing is similar to any other options strategy:
- Select the stock from your portfolio: It’s best to pick stocks with moderate volatility, which would yield decent option premiums and would still be relatively predictable. Again, you need to have 100 shares to write one option.
- Select an expiration date: This could be a few weeks or years away. Remember that the further you go into the future, the more expensive the option would be, fetching you a higher premium, but it’s also harder to predict what would happen.
- Select a strike price: Usually, the closer the strike price to the current share price, the higher the option premium would be. Ideally, this should be a price for which you would be happy to sell the stock.
You can play around with specifications and check market prices for different strikes and expiries. But don’t just try to sell the most valuable option. Those are expensive for a reason and are more likely to expire in the money.
For example, options for AMC Entertainment Holdings Inc. (NYSE:AMC) are very valuable as of August 2021. The share price is at $35, and an at-the-money call option with a $35 strike price expiring in just over two weeks costs $4.40. Writing this option would yield 12%. But it comes with high risks: AMC is one of the so-called meme stocks with high volatility. In April, it was under $10, and by June, options traders pushed it all the way to $59. Even in two weeks, the share price could easily move in either direction by more than the 12% you’d get for writing the option.
Finally, writing options doesn’t involve any actual writing or even signing. In the back end, your broker will create a new option contract, sort out all the legal details, and list the option on an exchange. From your perspective, the whole operation would look just like a regular options transaction.
The Best and Worst Time to Write Covered Calls
The best time to write call options is when you would be happy with both potential outcomes: selling the stock for the strike price or keeping the stock.
This is usually the case for long-term stocks that you might be holding for dividend income and don’t expect the share price to go up in the short term.
Covered call writing isn’t best when you’re very bullish or very bearish.
If you expect the share price to go up a lot, you’re better off just holding the long position in that stock and not risk missing the upside. And if you expect the stock price to go down, you should simply sell and close your stock position because the premium will likely not offset the loss.
Advantages and Risks of Covered Calls
As with any trading strategy, covered call writing has both advantages and risks.
The main advantages of covered call writing are:
- Downside protection: The premium you immediately collect can at least partially offset the loss if the stock price goes down.
- Increase the total return: Option premium payments are another source of portfolio income.
- Simplicity: You don’t need to worry about volatility or option Greeks, and your choices are limited to just the stocks in which you have a position of at least 100 shares.
- Time decay is on your side: If the stock isn’t going up, the price of the call options will decline every day, allowing you to buy back the option and close your trade early.
Of course, having a stock and an option instead of just owning stock also introduces additional risks:
- Risk of missing the upside of the stock: If the stock price rises above the strike price and continues to surge, you’ll miss those gains because your stocks were called away.
- Lower flexibility: You have to maintain your long position in the underlying security while you have an open short position in the option. Of course, you can sell the stock but you would first need to buy back the option, which would be harder to do.
- Potentially higher taxes: These are hard to predict beforehand because you don’t know if and when the shares might be called. If you’re forced to sell the shares, you might be up for short-term capital gains taxes and, in some cases, might lose the benefits of lower tax rates for qualified dividends.
To sum up, covered call writing is a relatively low-risk strategy, but it’s not free money. (That simply doesn’t exist.)
Your Turn to Boost Income With Options
As we have seen, writing options could be a great way to supplement income from stocks you already own. Writing covered calls is a fairly straightforward strategy with limited risk and is suitable for most investors who have at least 100 shares of a stock.
Of course, if you’re completely new to options trading, that might still be too much to take in. You don’t have to start with big trades or do it alone. The options market regularly throws opportunities that are up for grabs with spare change that you can find in your home. Sign up for Investors Alley’s Options Floor Trader PRO to learn how to spot these option trades.