Selling call options on stocks you own can be an effective way to generate additional income from your portfolio. Continue reading to learn how to use covered calls as part of an options income strategy to potentially boost your investment returns.
What Are Covered Calls?
Covered calls involve owning a stock and selling a call option on it at the same time. “Covered” means you own the stock, making it safer than selling call options without owning the stock.
Key Components of Covered Calls:
- Stock Ownership: You must own the stock or acquire it before writing the call option.
- Selling Call Options: You write (sell) call options, giving the buyer the right, but not the obligation, to purchase the stock at a predetermined price (strike price) within a specified period.
For more information, check out CBOE’s “How Call Options Work.“
Why Use Covered Calls?
Covered calls offer several benefits that can improve your overall investment strategy:
Income Generation
By selling call options, you receive a premium, which becomes immediate income, regardless of whether the option is exercised. Over time, these premiums can provide a steady source of income from your existing stock holdings.
Downside Protection
The premium received from selling call options can help offset potential losses if the stock price decreases. Although this doesn’t eliminate risk, it provides a cushion against market volatility.
How to Implement Covered Calls
To successfully implement a covered call strategy, follow these steps:
Step 1: Get Approved for Options
Before trading options, you will need to be approved by your brokerage. They will ask about your financial situation, investment experience, and understanding of the risks involved with options trading.
As an example, see what major brokerage firm Fidelity suggests you consider before applying for options trading approval. And for further reading, you may want to review Schwab’s Explanation on Covered Calls (no endorsement of Fidelity or Schwab is implied).
Step 2: Select the Right Stock
Choose a stock that you already own or are willing to purchase. You will need at least 100 shares. Ideally, the stock should exhibit favorable optionality with stable or modest expected growth rather than extreme volatility.
Step 3: Choose the Option’s Strike Price and Expiration Date
Determine the strike price and expiration date for the call option. This step is key and can often mean the success or failure of a covered call strategy, and it is why it is often wise to work with an experienced professional like the team at Optic Asset Management. The strike price is set above the current stock price to allow for potential stock appreciation while still earning the premium. The expiration date can range from a few days to several months, depending on your investment horizon and how active you plan to manage your positions.
Factors to Consider:
- Expiration Date: Longer expiration dates may provide more premium but lock you in for a longer period.
- Strike Price: A higher strike price generally offers less premium but more room for stock appreciation.
Step 4: Sell the Call Option
Once you’ve selected the strike price and expiration date, it’s time to sell the call option. You can do this through your brokerage account. Ensure you understand the terms and potential outcomes, including the possibility that your stock may be called away if the option is exercised.
Step 5: Monitor and Manage
Keep an eye on the stock’s performance and the status of the call option. If the stock price approaches the strike price, you need to decide whether to let the option be exercised or to buy back the option to maintain ownership of the stock. Buying back the option will reduce (or eliminate) the net premium income you receive, but it will allow you to keep the stock if you are not ready to sell it. Again, having a team like Optic Asset Management that can monitor and take care of all of this for you can be very helpful.
Examples
Let’s consider two scenarios to illustrate how covered calls can generate income:
Scenario 1: Stock Price Remains Flat
Imagine you own 100 shares of XYZ Corp at $50 per share. You sell a call option with a strike price of $55, expiring in one month, for a premium of $2 per share.
- Premium Earned: $2 x 100 shares = $200
- Outcome: If the stock price remains at $50, the option expires worthless, and you keep the premium. You can then repeat the process, continuing to generate income.
Scenario 2: Stock Price Rises Above Strike Price
You again own a 100-share position in XYZ Corp at $50 per share, but the stock price of XYZ Corp rises to $60. The call option is exercised, and you must sell your shares at the strike price of $55.
- Premium Earned: $2 x 100 shares = $200
- Capital Gain: ($55 – $50) x 100 shares = $500
- Total Income: $200 (premium) + $500 (capital gain) = $700
In this scenario, you benefit from both the premium and the capital gain, although you’ve sold the stock at a lower price than the current market value. To avoid the sale, you would need to buy back the option before it is exercised.
Risks of Covered Calls
While covered calls offer numerous benefits, there are also risks to consider:
Limited Upside Potential
When you sell a covered call, you agree to sell your stock at a specific strike price if the option is exercised. This means that if the stock price rises significantly above the strike price (as described in Scenario 2 above), your gains are capped at that strike price. You miss out on further upside potential unless you buy the call back (and thus reduce your income) prior to the exercise date.
Market Volatility
Covered calls provide some downside protection through the premium, but they do not eliminate the risk of losses due to market downturns. If the stock price falls significantly, the premium received from selling the call may not be enough to offset the loss in the stock’s value. If that is a concern, a collar strategy involving put options may be better suited than a call-only approach.
For a comprehensive list of risks, you should review CBOE’s Characteristics and Risks of Standardized Options.
Tax Considerations
Selling covered calls can have tax consequences, particularly if the option is exercised. Depending on the timing and your tax situation, this could result in short-term capital gains, which are typically taxed at a higher rate than long-term capital gains. You should contact a professional tax advisor prior to entering into any options trading strategy.
For a comprehensive list of risks, you should review CBOE’s Characteristics and Risks of Standardized Options.
Conclusion
Covered calls can be a helpful way to generate additional income from your investments. By carefully selecting stocks, setting appropriate strike prices, and proactively managing your option positions, you can enhance your portfolio’s returns while mitigating some risks.
That said, options trading strategies can be complicated and are not suitable for everyone. Optic Asset Management actively manages covered call strategies for high-net-worth individuals, utilizing proprietary analytics and customized software to help investors meet their financial goals. If you’re considering an options strategy, please contact Optic Asset Management today to learn if an Optic strategy is right for you.
Disclosures
Investing in options carries significant risks and isn’t suitable for everyone. Strategies like covered calls can result in financial loss. Carefully consider your investment goals and risk tolerance. Past performance doesn’t guarantee future results. Transaction costs and fees will affect the performance of any options trading strategy and can have a meaningful negative impact on performance over time. Consult a qualified financial advisor and a tax professional before trading options. Get approved for options trading by your brokerage/custodian and read all disclosures, terms, and prospectuses provided to you, including the CBOE’s Characteristics and Risks of Standardized Options. No offer or solicitation should be implied by the content of this article, which is intended to be informational and educational only.
