Alternate name: Writing covered calls
A covered call strategy involves two steps: First, you have to buy shares of stock. You can select the stock using any method you prefer. As with any investment, it’s important to do your due diligence. Covered call strategies work well with stocks that have stable prices and aren’t volatile. Second, you sell call options against the stock that you’ve purchased. Call options give the buyer the right, but not the obligation, to buy shares at a set price. When you sell the option, the buyer has to pay you a premium; you get to keep it as income from selling the option. Each option contract typically involves 100 shares.
How Does a Covered Call Strategy Work?
A covered call strategy is a popular options strategy. It’s often considered low-risk, compared to others. It can help you generate income from your portfolio. Many brokerages will allow the selling of covered calls even in accounts that aren’t authorized to trade other options. The reason covered calls are seen as low-risk is that the loss you can experience is limited. With some other options contracts, you can be exposed to theoretically infinite risk. “Covered calls can be a great source of income, but you should always be ready to lose the underlying stock,” Henry Gorecki, CFP, told The Balance. “Think twice about writing calls on the stock of a great, growing company that you may want to hold on to for long-term appreciation.” With a covered call strategy, you’re not just protecting yourself from losing money. You’re also placing a limit on how much you can earn from an increase in the stock’s price. In exchange, you receive income in the form of the premium paid by the option buyer.
Example of a Covered Call Strategy
Jane buys 100 shares in company XYZ at $50 each, for a total value of $5,000. She expects the share price to rise, and she sells one options contract with a strike price of $55 to Joe. Joe pays a premium of $20 for this call option. If the share price doesn’t rise above $55, Joe is unlikely to exercise the option; it would then expire. When that happens, Jane gets to keep her shares and pocket the $20 Joe paid her. Her total profit or loss will be $20, plus or minus any changes in the price of XYZ from when she bought it $50 per share. Jane’s best-case scenario here is that the stock rises in value to exactly $55 before the option expires, but Joe does not exercise his option. If this happens, she gets to keep the $20 she received from Joe and her shares, which are now worth a total of $5,500. Combined with the $20 she received from Joe, her total gain is $520. The worst-case scenario is if XYZ’s shares become worthless. If that happens, Jane will lose her initial investment of $5,000. However, she gets to keep the $20 Joe paid her. That would put her total loss at $4,980. If XYZ increases to $60 per share before the option expires, Joe can exercise the option. He’ll pay Jane $55 per share. Jane will then keep the $20 premium and receive $5,500 from Joe for her 100 shares. That would make her overall profit $5,520. However, she would lose out on potential profits, because she could have sold her shares for $60 each. She could have made $6,000 instead of just $5,500. But the call she sold to Joe forces her to settle for just $55 per share, plus the $20 premium.
Stock Ownership vs. Covered Calls
When you buy a stock, you accept the risk of the stock losing some or all of its value. The value of your investment increases as the stock price rises. While stock ownership is simple, in some cases selling a covered call may prove to be more profitable. The below table shows how your investment gets impacted by stock price changes when you own a stock, compared with when you sell a covered call. “Net gains and losses on covered calls are short-term capital gains and losses,” Gorecki said. “Short-term capital gains are taxed like ordinary income.” That means you could end up paying more in taxes than you would with long-term capital gains. But it’s not as simple as that. When an option gets exercised, Options Clearing Corporation (OCC), the options industry clearing house, randomly assigns the exercise notice to brokerage firms with a client account that has an equivalent option position. This process is called “assignment.” Once that happens, short-term or long-term capital gains or losses will be determined by the “strike price plus the premium received, as well as the cost basis and holding period of the underlying stock.”
Pros and Cons of Covered Calls
Pros Explained
Generate additional income from shares you own: When you sell a covered call, you receive a premium payment from the buyer. If you want to earn income from your portfolio, this strategy can help you make money each time you sell a call. Help you set a target selling price for stock you own: Using covered calls allows you to target a selling price, higher than the current market price. Losses are finite, compared to other riskier options trading strategies: Even in the worst-case scenario, if the stock drops to $0, and the shares become worthless, the loss is finite, as opposed to other options strategies that may expose investors to infinite losses.
Cons Explained
Limit your potential gains from any future stock price increases: The most you can make when selling a covered call is the premium you receive, plus the difference between the strike price and the current price per share. If the price of that share increases above the strike price, you’ll still have to sell the shares at the strike price.Must continue owning the stock until your options expire: Sometimes, plans change, and you want to sell some of your investments. For a call to remain covered, you have to own the shares until the option expires, which might force you to hold the shares for longer than desired.Net gains are subject to capital gains taxes: You may have to pay short-term or long-term capital gains taxes based on a number of factors.
What It Means for Individual Investors
Selling covered calls is a popular strategy for long-term investors who want to generate extra income from their portfolios. The key to success in covered call strategies is to pick the right company to sell the option on. Then, select the correct strike price. Simple covered calls work best, so long as the price of a stock stays below the strike price of the contract. It also provides a slight limit on potential losses, as you can not lose the premium you receive from selling the option. The primary risk of the strategy is that you miss out on gains if the value of your investments jumps too quickly. If you’re ready to dip your toes into options trading, covered calls might be a good way to start. In some cases, selling a covered call may prove to be more profitable than owning the stock. But options trading is complicated; it’s not for everyone. Weigh your risk appetite before making any decisions.
