Selling Covered Calls
Selling covered calls is a popular strategy used by investors to generate additional income from their stock holdings. In this strategy, an investor sells call options on a stock they already own, giving the buyer of the option the right to purchase the stock at a specified price, known as the strike price. In exchange for selling the call option, the investor collects a premium, which they get to keep regardless of whether the option is exercised or not.
In this article, we will explore the ins and outs of selling covered calls, including how to choose the right strike price and expiration date, how to manage the position if the stock price moves against you, and the potential benefits and risks of this strategy. Whether you are a beginner or an experienced investor, this article will provide valuable insights into the world of covered calls and how to use them to your advantage.
What Is a Covered Call?
A covered call is a financial options strategy that involves selling call options on a stock that an investor already owns. In this strategy, the investor holds a long position in the underlying stock and simultaneously sells call options on that stock, giving the buyer of the option the right, but not the obligation, to purchase the stock at a predetermined price, known as the strike price, on or before a specified date, known as the expiration date.
The investor who sells the call options is paid a premium for the option, which they keep regardless of whether the option is exercised or not. If the stock price remains below the strike price at expiration, the investor keeps the premium and the stock. If the stock price rises above the strike price, the investor must sell the stock at the strike price, but still gets to keep the premium, which can offset some of the potential losses.
A covered call is considered “covered” because the investor already owns the underlying stock, providing a hedge against potential losses in case the stock price rises significantly. The risk in this strategy is that if the stock price rises above the strike price and the option is exercised, the investor will miss out on any potential gains above the strike price.
Selling Covered Calls Example
Let’s say you own 100 shares of XYZ stock, which is currently trading at $50 per share. You believe the stock price will remain relatively stable over the next few weeks, so you decide to sell a covered call option.
You look at the available options for XYZ and decide to sell a call option with a strike price of $55 and an expiration date of one month from now. The current market price for this call option is $2 per share, so you sell one call option for 100 shares, earning a total premium of $200 ($2 per share x 100 shares).
Over the next few weeks, the price of XYZ stock remains stable and the option expires worthless. As the seller of the option, you get to keep the premium of $200. You can now choose to sell another call option and repeat the process, or hold onto your shares and wait for another opportunity to sell a covered call.
Alternatively, if the price of XYZ stock had increased above $55 before the expiration date, the buyer of the call option could exercise their right to buy your shares at the strike price of $55 per share. In this case, you would sell your shares for a profit of $5 per share ($55 strike price – $50 purchase price), plus the premium of $2 per share, for a total profit of $700 ($5 per share x 100 shares + $2 per share x 100 shares). However, if the price of the stock had dropped below the strike price, the option would expire worthless and you would keep the premium as your profit.
How to Sell Covered Calls
Here are the general steps to sell covered calls:
- Choose a stock: Select a stock that you already own or are willing to buy, and that you think will remain relatively stable in price or increase in value over time.
- Determine the strike price and expiration date: Look at the available options for that stock and decide on a strike price and expiration date that suits your needs. The strike price should be above the current stock price, and the expiration date should be a few weeks to a few months in the future.
- Sell the call option: To sell a covered call, you would need to have at least 100 shares of the underlying stock. You can then sell a call option for each 100 shares you own. Use a trading platform or broker to sell the option at the current market price.
- Collect the premium: The premium is the price paid by the buyer of the call option. As the seller of the option, you collect this premium as income. The premium will vary based on the stock’s price, strike price, expiration date, and other factors.
- Monitor the trade: As the seller of the option, you have an obligation to sell your shares at the strike price if the option is exercised by the buyer. Therefore, it’s important to monitor the trade regularly and be prepared to sell your shares if necessary.
- Repeat the process: If the option expires worthless, you can sell another call option and continue to generate income from your shares.
Selling covered calls can be a useful strategy for generating additional income from a stock you already own, but it does require careful monitoring and management.
How to Adjust Covered Calls
Adjusting covered calls involves making changes to your existing position in response to changes in the underlying stock’s price or other market conditions. Here are some ways you can adjust covered calls:
- Roll up: If the price of the underlying stock rises above the strike price of the call option you sold, the option may be exercised and you will be forced to sell your shares at the strike price. To avoid this, you can “roll up” the call option by buying back the original option and selling a new option with a higher strike price. This will allow you to keep your shares and potentially earn a higher premium.
- Roll down: If the price of the underlying stock falls significantly, the premium for your call option may decrease, making it less attractive to potential buyers. To avoid this, you can “roll down” the call option by buying back the original option and selling a new option with a lower strike price. This will allow you to earn a higher premium and potentially reduce your risk.
- Buy back: If the price of the underlying stock rises significantly and you believe it will continue to rise, you may want to buy back the call option you sold before it is exercised. This will allow you to keep your shares and potentially sell another call option at a higher premium.
- Sell more: If the price of the underlying stock falls and the premium for your call option decreases, you may want to sell more call options to earn additional income and potentially reduce your cost basis for the shares you own.
It’s important to note that adjusting covered calls involves risks and requires careful consideration of market conditions and your investment goals.
Pros and Cons of Selling Covered Calls
Selling covered calls can be a profitable strategy for investors looking to generate additional income from their stock holdings. However, like any investment strategy, there are both pros and cons to consider before implementing this strategy.
- Lower cost basis: By collecting premiums from selling covered calls, investors can effectively lower their cost basis on the underlying stock, potentially increasing their overall return on investment.
- Potential to outperform the market: In a flat or slightly bullish market, selling covered calls can potentially outperform a buy-and-hold strategy on the underlying stock, as the investor collects premiums while the stock price remains steady or rises slightly.
- Flexibility: Investors have flexibility in choosing the strike price and expiration date that best align with their investment goals and risk tolerance.
- Opportunity cost: By selling a call option, the investor gives up the opportunity to benefit from any gains above the strike price of the option.
- Limited upside potential: If the stock price rises significantly, the investor’s potential gains are limited to the premium collected plus the difference between the stock price and the strike price of the option.
- Risk of loss: If the stock price falls significantly, the investor may experience a loss, which could be amplified if the premium collected does not fully offset the decline in the stock price.
- Complexity: Selling covered calls requires some knowledge and experience, and it may be difficult for beginners to properly execute this strategy.
While selling covered calls can be a profitable strategy for income generation and risk management, it is important for investors to carefully consider the potential risks and rewards before implementing this strategy.
The Bottom Line
In conclusion, selling covered calls can be a profitable strategy for investors looking to generate additional income from their stock holdings. By selling call options on stocks they already own, investors can collect premiums and potentially earn additional profits if the stock price remains steady or rises slightly.
Selling covered calls can be a valuable addition to an investor’s portfolio, but it should not be the sole investment strategy. By combining this strategy with a diversified portfolio and a long-term investment outlook, investors can potentially enhance their returns while managing risk.