3 Ways to Profit Using Covered Calls

03/22/2011 3:00 am EST

Focus: OPTIONS

A covered call strategy, though basic, is a proven-effective way to generate steady cash flow. Here are three ways to execute as well as important risk factors and other considerations to watch for.

By Ross Jardine

The following is an excerpt from Build Wealth in Any Market

Our first strategy is a covered call. This is a powerful income-producing strategy that helps you generate immediate cash flow from the stocks you own. This is an excellent strategy to start with if you’re new to options because it is so conservative. The covered call strategy is actually less risky than owning stock outright because you collect a premium that provides a little insurance against a drop in the price of the stock. You only need to be approved for level-one trading to do the covered call strategy, and most brokerage firms will allow you to do this strategy in a retirement account, like an IRA.

When it comes right down to it, there are really only three ways to make money on a stock:

  1. Buy the shares and hope to sell them at a later date at a higher price than you paid for them

  2. Collect a dividend that is paid quarterly by many public companies. The problem here is that many companies don’t pay dividends and the actual dividend yield for those that do is often very small; so it’s not the primary motivation to buy a stock

  3. Sell options on the stocks you own to generate consistent and reliable income from them regardless of whether they are going up, down, or sideways

This third way to make money with stocks is probably the least understood and, in my opinion, the most powerful and consistent. The fact is that most investors I’ve taught in my seminars over the years are amazed when they learn this strategy. Most comment that they never knew you could generate income from stocks you own, and many wonder why their broker or financial advisor never told them about this strategy. The truth is that most simply don’t understand it, so they never recommend it.

I think this strategy is a great way to learn the concepts of options because it is so forgiving. In this strategy, we put time on our side, unlike buying an option where time is our enemy. This will allow us a lot of flexibility. You can be a little bit wrong in your forecast for the stock and still potentially make a profit with the covered call strategy. You cannot say that about many strategies in the investment world, but you can about this one. 

To help you understand the concept behind the covered call strategy, think back to the example of the homeowner who entered into the lease with the option to buy. He owned the home and was able to generate $5,000 in immediate income by giving your friend the right to buy the home for $100,000 during the next two years. He basically sold a call option to your friend that allowed him to “call away” his home at anytime during the term of this contract for $100,000. Since he owned the house, he was “covered” in that he would be able to fulfill his obligation to deliver the house to the buyer for $100,000, regardless of the price of the house at the time. This homeowner did what is called a “covered call” in the options world, and it’s one of my favorite option strategies.

We use this same approach in the stock market to generate income on optionable stocks we own. When doing a covered call, we sell, to another investor, the right to buy our stock for a predetermined price. This is a transaction with an investor we will never know or meet. We get paid in advance, but tie up our stock for the term of the contract. If the stock doesn’t rise past the price we agreed to in the contract, we get to keep our stock because the predetermined price is higher than market and not a good deal. If it goes above the strike price of our contract, we have to sell it because the guaranteed price is now lower than the market and a good deal for the investor with whom we struck the deal.

The foundation of covered calls is that you must own stock. If you sell an investor the right to buy stock from you that you don’t already own, you have unlimited risk. If the stock goes $100 above the price you agreed to in your contract, you have to go into the market and buy the stock, only to turn around and sell it for the lower price to which you agreed. This is called a “naked call” because you did not own the stock to “cover” your obligation.

Covered call selling is one of the most conservative option strategies. In fact, it’s the only option strategy that most brokers allow you to do in a retirement account. It’s also a very powerful income strategy that most investors simply don’t understand. The best part about this strategy is that we don’t have to find another investor to buy the call options we want to sell. The market finds someone for us. We simply have to say we want to do it and place the order. Isn’t America great?

Let’s look at how you can begin to take advantage of this powerful strategy and generate immediate cash flow from the stock you own—regardless of the market trend.

NEXT: What Are the Pertinent Risk Factors to Consider?

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What Are the Risks?

Overall risk is less than owning stock. Selling covered calls is actually less risky than owning stock because you create some income that provides a small cushion against a decline in the value of the stock. It’s like someone paying rent on a house you own.

Opportunity risk or potential missed profits. A more subtle risk associated with this strategy is the opportunity risk. When you sell a covered call, you agree to sell your stock at a set price. That, in effect, puts a ceiling on your potential profits. If the stock goes above that price, you cannot participate. The person who bought the call option from you earns that profit. Your profit is limited to the strike price of the contract, plus the premium you were paid to enter into the covered call play. And, since option trades settle in one day, unlike stock trades that take three days, the income hits your account the day after you sell a call option.

You may feel badly about missed profits if you have given someone the right to buy your stock for $40 per share by selling them a call option, only to see the stock go to $50 by the expiration day. But, like we said earlier, lost opportunity is much easier to take than lost money.

What Are the Benefits?

Generate monthly cash flow from stocks you own. The appeal of covered calls is the income. If you own stocks with options, you have the potential to generate a paycheck from that stock every month for the rest of your life. This is a powerful principle that is understood by very few investors.

Downside protection. The income from selling call options gives you a bit of downside protection on your stock in the event of a sudden decline in the value.

Ride out the Dips. This income also provides an easy way to ride out the dips that all stocks make from time to time.

Three Ways to Use Covered Calls

1) Buy-Write Strategy

When you see the word “write” associated with option investing, it implies you are “selling” options, as is the case with a covered call. This is the approach you might use if you don’t already own a stock that would allow you to do covered calls. You could identify an optionable stock, go into the market and buy some shares, and then immediately sell call options against those shares to create income. Those who use this approach are not trying to make money on the purchase and subsequent sale of the stock, but are trying to create a reasonable return from the income on the options alone. An ideal buy-write play may result in a wash on the stock, but the income from the call options provides a profit, from a slight percentage to as much as 15% on the total money invested in the stock, in as little as a month. This is a conservative approach to covered calls.

For example, we find a stock that is trading for $20 per share and the $20 call option is selling for $2. We go into the market and buy 100 shares of the stock for $2,000, and then immediately sell one contract of the $20 call and collect $200 the next day. We have given someone the right to buy the stock we own for the same price we paid for it. If the stock is above $20 on the expiration day, they will buy our stock. We get back our $2,000, and also keep the entire $200 we collected from selling the call option. We now have $2,200 in cash in our account. We’ve made a 10% return that month and can begin looking for another stock with which we can do it all again.

2) Legging in

This is a more aggressive approach to covered calls that involves looking for stocks that are trending up and then buying them to hold while they rise. Stocks that have the green, or up, arrows we’ve learned about are good candidates for “legging in.” After you purchase the stock, you hold it until you see that it is beginning to slow down. This may be indicated by the peaking of the MACD or red, or down, arrows on any of the indicators. At that moment, sell a call option and collect the income. By waiting while the stock is still rising, the investor is able to earn more profit on the stock, and the income is simply added on. The risk involved in legging in is that far too often you buy a stock in hopes that it will rise so you can sell a covered call, and instead it goes down in price. Now you own a stock that has fallen in value and the income you could have earned by selling the call options is not enough to offset your loss.

For an example of how legging in works, we buy XYZ stock just as it is breaking out, as indicated by the green, or up, arrows. We pay $20 per share for 100 shares. We hold the stock for a week and it rises to $25. It looks as if it will continue to rise. We see that the $30 call option is selling for $1, so we sell one contract and collect $100. The stock continues to rise and on expiration day it is at $32, $2 higher than the strike price of the call option we sold.

The owner of the call option exercises his/her right to buy our 100 shares for $30 as we agreed. Since we paid only $20 for this stock, we have earned a $10 per share profit. But that’s not all; we also earned another $1 from the income on the call option, making our profit $11 per share, or $1,100. We earned all the profit between our purchase price and the strike price of the call option we sold, plus the income from the covered call.

3) Exit Strategy

Some investors like to use the covered call strategy to exit a stock position they think has little potential of continuing to rise. They do this by selling a call option with a strike price just below the current price of the stock. This increases the probability that the person who bought this call option will exercise their right to buy this stock at the strike price. But since the strike price is lower than the current price of the stock, the call buyer is going to have to pay the stockowner a larger premium for this right. This larger premium makes up for the small discount the stock owner is giving the call option buyer, and usually allows them to make a bit more than the strike price on the sale of their stock.

For example, let’s say you bought some AOL stock a year ago for $50 and it’s now trading for $78. Based upon your analysis of the stock, you feel it won’t be going up much more from here, but you’re hesitant to sell it now because you don’t want to miss out if it moves higher.

We decide to sell a call option with a strike price of $75 ($3 below the current price of AOL) because we can collect $6 per share (the premium for the call option). Now, if the stock remains anywhere above $75 on expiration day, you are obligated to sell your stock for $75. However, with the additional $6 you collected from the call option, your actual selling price is $81. The best part is that you get $81 even if the stock drops to $75 from $78 because you are going to get “called out” of your stock at any price above $75. You earn an extra $6 by selling the call option you might not have earned if you had held onto your stock.

NEXT: Selecting Stocks for Covered Calls

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Selecting a Stock for a Covered Call

In order to do the covered call strategy on a stock, the first thing, of course, is that the stock must have options available.

Stocks in the $10 to $50 price range generally offer some of the best potential returns. The reason for this is that the price of a call option is not necessarily tied to the price of the underlying stock. In other words, the at-the-money call option for a $20 stock may be trading at $2, which represents a 10% potential return on the income from the call. By contrast, the at-the-money call option for a $100 stock may only be trading for $4, which represents only a 4% potential return from the income. Since you must own the stock to do the covered call strategy, buying more expensive stocks often makes it difficult to get the same potential returns as you can get with lower-priced stocks. This is not to imply that it’s impossible to get a decent rate of return doing covered calls on higher-priced stocks. It’s just that it is rarer. The most notable exceptions are very volatile stocks like technology and Internet companies where the options are extremely expensive and offer comparable potential returns.

A word of caution: Just because you can get the same potential rate of return on a high-priced stock doesn’t mean it is conservative. Be sure to factor in the added volatility of the stock and determine if the stock is suitable for you to own considering your tolerance for risk.

Minimum Potential Monthly Return

We suggest only considering stocks for covered calls with a minimum potential return of 3%-5% per month or better. This is not to say that if you can’t get 5%, you shouldn’t do covered calls. If you already own a stock and would like to do covered calls on it, the best potential return you can get is 2%- 3%, and that’s better than nothing. The point to understand is that if you’re looking to invest new money in a stock to do covered calls, limit your prospects to those stocks that offer, at the very least, a modest rate of return. The covered call report tool, on the toolbox, screens potential candidates to find only those stocks that offer a minimum 5% monthly return or better from the call income.

Minimum Open Interest

Try to avoid doing covered calls with options that have little or no open interest. Open interest is a key indicator of activity in an option contract. Liquidity is better the higher the open interest is in an option contract. This usually translates to tighter spreads and fairer prices. The option interest for each contract is usually displayed on the option quote chain along with the current bid and ask prices. Contracts with low open interest generally have wide price spreads between the bid and ask and might be difficult to sell at a fair price. We suggest avoiding contracts with less than 50 contracts of open interest. If you insist on selling a contract with less than 50 contracts of open interest, use a limit order on the call to make sure you get a fair price.

To enter a covered call trade, you must first own the stock you are planning to play. You must own 100 shares of stock for each call option you sell. For example, if you own 500 shares of XYZ stock, you could sell five call options on XYZ. You do not have to sell five, but that is the maximum you could sell and still be covered. Since selling a call option carries with it the obligation to sell 100 shares of the underlying stock at the strike price of the contract, owning 100 shares of the underlying stock assures that you will be able to meet that obligation should the circumstances require it; thus you can “cover” your obligation. That’s where the strategy gets its name.

You sell a covered call by placing a “sell to open” order for the contract with the strike price you have selected. Think of the strike price as the price at which you are willing to sell your stock. The closer the strike price to the current price of the stock, the higher the premium that you will collect for selling the call option. The higher the strike price you select, the less the premium. You can also select the expiration month for your call option. That is the date that the buyer of the call option has to decide whether to exercise their right to buy your stock or not. Quite simply, they will only exercise that right if the strike price of the call option they bought is less than the current price of the stock in the open market.

On expiration day, if the stock is higher than the strike price of your covered call, your stock will be called away. This is all handled automatically by your broker. Your shares are sold at the strike price of the call and the cash is deposited in your account. The obligation to sell stock has been fulfilled. You also get to keep the premium you collected at the time you entered the covered call trade. So your net return is the selling price of the stock plus the premium you collected from the option contracts. You are now free to use that money for whatever you wish. You can find another stock to purchase and do it all over again.

If the stock is below the strike price of the covered call on expiration day, you will be able to keep your stock, which would be worth the current price as quoted in the market. You would also keep the premium you collected when you entered the covered call trade. Once expiration day passes, the obligation associated with the call option expires, and you are free to choose another option to sell for a future expiration month in return for another premium.

If the stock has dropped while you had the covered call position in place, you are still at risk of losing money. The premium collected will provide a small amount of downside protection; but, if the stock should drop farther than the amount you collected in premium, you will be losing some of your initial investment. This is the primary risk of a covered call trade—stock ownership. The positive thing is that you have a small amount of insurance from the premium you collect from the covered call that you would not have if you didn’t employ the covered call strategy. That’s why I like to say that doing covered calls is less risky than just buying stock and doing nothing.

You can close out a covered call trade anytime prior to expiration by first buying to close the covered call position. This trade will offset the trade you placed to enter the covered call trade and remove the obligation to sell stock. Once you have closed out the covered call position, you are free to sell your stock if you choose. If you don’t close the covered call position first before selling your stock, you will create a “naked call” position. This is one of the riskiest option trades you could make and one that is only allowed for the most sophisticated and financially strong investors. The reason this is the case is because you still have the obligation to sell stock by virtue of the call option contract you sold and now you no longer have the shares to “cover” that obligation. Should the call option be exercised, you would have to buy stock in the open market, perhaps at a much higher price and then turn around and sell it at the strike price of your covered call to fulfill the obligation. Fortunately, most brokerage firms employ sophisticated systems that keep investors from ever getting into a naked position.

By Ross Jardine, author, Build Wealth in Any Market

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