One of the most straightforward and most popular options-based strategies is the covered call.
Covered calls are a smart way to generate extra income from stable predictable stocks you own. In other words, as long as the stock isn’t too volatile and doesn’t have a significant beta, selling covered calls is a smart trading strategy.
But before you jump into using the covered call, you’ll want to understand more about it. So, we’ll break down the covered call, explaining what it is, when and why to consider it, and the pros and cons of the strategy.
The Basics: What Is a Covered Call?
When an investor owns stock and sells call options to buy that stock — at a predetermined price within a certain period of time — to another party, you have a covered call.
The stock owner, who is also the option seller in this case, receives cash upfront from the option buyer. This is called a premium.
The buyer pays this premium on the day the option is sold. The seller keeps the premium whether the option is exercised or not.
If the option contract is exercised, the stock owner sells the stock at the strike price. If the option is not exercised, it expires, and the stock owner maintains possession of the stock.
Most people are already familiar with calculating profit and loss from simply owning a stock and then selling it. But since you receive a premium at the time you sell a covered call, your profits immediately increase.
You’re also getting some protection if the value of your shares decline. Think about it. Your shares can drop in value by as much as you collected on the covered call sale without losing value on your position.
Call Options vs. Covered Call Options
To really get a handle on covered call options, it’s important to step back and review the basics of stock ownership in general.
When you purchase a stock, you also purchase the right to sell that stock at any time in return for the market price. With a covered call, you sell this right to another investor in exchange for cash.
When selling or writing a standard call option, you’re only selling the option to buy shares of an underlying stock at a certain price, the strike price, on or before a certain date, the expiration date.
In the case of a covered call option — or covered call writing — the option writer also owns the underlying stock. In essence, you create a covered call by owning the stock and then writing and selling call options on that stock at a set price at some point in the future.
What Does an Actual Covered Call Look Like?
Let’s say you own 100 shares of XYZ stock.
The current market price is $10 per share. You sell a call option for these 100 shares of stock to another investor for $1 per share. The option has a strike price of $12 and an expiration date two months from now.
Since the buyer is purchasing the call option at $1 per share, you pocket $100. (We’re going to ignore commissions and fees for the sake of clarity.)
That $100 is yours no matter what happens next.
If the stock price hits $12 in the next two months, you have to sell the stock to the other investor. If not, you keep the $100 and the stock.
Why Use a Covered Call?
The next logical question becomes: Why would an investor choose to get involved with covered call positions?
Investors may include covered calls in their strategy to reach core investing objectives, to meet longer-term goals, to replace dividends, or to protect against risk.
Core Investing Objectives
Any time you are deciding about a new investment strategy, it’s a good idea to circle back to your core investing objectives.
The objectives for most people fall in one of these categories: capital gains, income, or both.
And while options trading with covered calls is an effective method for generating extra income from stocks, there are many ways covered calls can produce capital gains as well.
Extreme volatility does not bode well for the covered call strategy. That’s why day traders seldom use covered calls.
You’ll want to avoid using covered calls on securities receiving a lot of stock market news coverage or those with significant risk events on the horizon, like a high-profile earnings release, mergers and acquisitions, or leadership changes.
Covered calls are typically for investors with longer-term objectives.
Large-cap blue-chip stocks can be ideal candidates for the covered call. Their greater liquidity profile tends to result in a more stable outlook and lower risk. Of course, lower risk means a lower premium too.
Covered calls can be a powerful income strategy if you’re willing to forego capital gains should the underlying asset move significantly above the strike price after the call option is exercised.
A covered call strategy can be used when a stable stock doesn’t pay a dividend.
Take Berkshire Hathaway (NYSE:BRK.B), for example. It’s a great stock to own because it’s very stable. But many of its investors are looking for a dividend, and Berkshire doesn’t pay one. So using covered calls with Berkshire Hathaway stock is a popular investment strategy.
Covered calls can also offer a degree of risk protection up to the amount of the premium. The option premium can sometimes offset minor downturns in the price of the stock and the resulting impact on your portfolio.
When To Use a Covered Call
You might use a covered call when you feel the market will be neutral or only slightly bullish. Your goal is to generate extra income in the form of premiums.
You’re betting that the stock price doesn’t reach the strike price. This way, you keep the premium and your shares. But you must also be able to tolerate the risk that the market price might move in such a way that you must let go of those shares.
A covered call will be most profitable if the stock moves up near the strike price.
Your portfolio becomes more valuable because of the long stock position, while the call that you sold expires without being exercised. The entire premium is pure profit.
However, even if the stock price does reach the strike price and the buyer exercises their right to purchase the stock from you, you have profited in two ways:
- From the premium you pocketed.
- From the profit generated by the upward movement of the stock prior to the sale
What’s the Downside?
As with most things, positives are balanced by negatives. So, you’re likely wondering, “What’s the downside here?”
Well, the downside is: Your upside potential is limited. Once the stock price appreciates beyond the strike price of the covered call option, you are no longer benefiting from an increase in value.
Here’s the quick and easy downside: Covered calls can rob investors of capital gains.
Remember, call buyers have options, but call sellers have obligations.
In other words, the call buyer has the option to purchase shares from you when they hit the strike price. But as the call seller, or call writer, you have the obligation to sell should the buyer exercise their right.
Let’s revisit our example. Remember those 100 shares of XYZ stock?
The current market price is $10 per share. You sell a call option to another investor for $1 per share. The option has a strike price of $12 and an expiration date two months from now.
You pocket $100.
If the stock price hits $12 and keeps on rising — to, let’s say, $20 per share — are you going to be able to stomach that missed opportunity?
Sure, you pocketed the $100. And you sold a stock you bought for $10 per share at $12 per share, making yourself an additional $200.
However, you missed the spike when the stock continued past $12 per share and hit $20 per share. So, in essence, you missed out on $800 of capital gains.
So, the question becomes: Is the risk worth the reward? And this is something that requires a good deal of consideration.
Seeking More Information About Covered Calls
Trading with covered calls involves a combination of timing, speculation, and experience. If you’re an investor who believes that the price of a stock will remain steady for a certain amount of time and you’re prepared to forego gains from an unexpected upward climb, covered calls might be a good addition to your portfolio.
Covered calls can help build an income stream that provides a greater degree of financial freedom now, next month, and for years to come. But how can you choose the right stocks to get started?
To learn how to find those stocks, identify interesting trade set-ups, and generate that extra income, subscribe to Investors Alley “Options Floor Trader PRO” newsletter.