What are covered calls and how do they work? Let’s discuss, writes Markus Heitkoetter of Rockwell Trading.
Let me introduce you to one of a trader’s best friends: the covered call strategy. At its core, writing covered calls is an investment strategy. This strategy shows you are bullish on the underlying stock for the long term.
Do I personally write covered calls? Of course! When I am assigned a stock and I want to collect weekly premiums, I sell covered calls to generate additional income. I am happy to continue selling calls and collecting that premium until my shares get called away.
For some traders, covered calls can be an excellent way to earn additional income on positions you already hold.
What Is a Call Option?
Let’s start with the basics and review what a call option is. Call options are contracts that give the option buyer the right, but not the obligation, to buy a stock at a certain strike price.
The strike price is the specified price at which the buyer wishes to buy the shares at. Just think of this as the selling price you would be happy to sell your shares at.
Each options contract represents the right to buy 100 shares of the underlying asset. So when you sell a covered call, it is with the expectation that you might have to sell your shares.
Options trading provides traders with the ability for a high-profit potential without needing a large amount of capital to start with.
What Is a Covered Call?
Writing covered calls is a trading strategy that involves two distinct steps:
- You need to already own 100 shares of the underlying stock
- You then sell or write a call option contract for that stock with a higher strike price than the current market price.
If you are new to options trading, this might sound a little confusing, so let me elaborate.
Most traders are probably more familiar with buying a call option contract, which means they are anticipating that the stock price rises above the strike price by the time the call option expires. This is similar to someone buying a lottery ticket, hoping that it will be worth more than what you paid for it.
Selling a call option contract does not mean you are not bullish on the stock. When you sell covered calls, it usually means you do not expect the stock price to rise very high in the short term.
One key to writing a successful covered call is if the stock price does not rise above the strike price by the time the call option expires. If this happens and the stock price drops, you have secured the premium from your covered call without having to give up your shares. In this case, you keep the premium and the shares!
I get it, it’s a weird feeling to be happy when the stock price declines, but you shouldn’t think about it like that. Think of it as hoping that the stock prices do not rise above the strike price of the covered call.
Even if it does, as long as the stock price climbs higher than your original purchase price, you’re still in the green!
Here’s a hypothetical example to give you a visual of what a covered call looks like.
Covered Call Example:
Let’s use the example of Apple (AAPL) as our underlying stock.
First, you will need to have stock ownership of Apple, with at least 100 shares in your brokerage account. If Apple is trading at $200 per share, you will want to select a strike price that is higher than $200. I like to use an expiration date for the call option at about five to seven days from the day you sell it.
When it comes to choosing the strike price, I usually look one standard deviation away from the current price of $200. Why? Because in the span of seven days, a stock is unlikely to move more than one standard deviation from its current price. This is key to the success of your covered calls. Pro-Tip: If you already own our premier options trading software, The Power X Optimizer, you know that the software also recommends strike prices for you.
When you sell an options contract, you collect the premium paid by the buyer of the contract. This becomes your premium income and is the basis of any covered call strategies. So back to our example of Apple stock. Let’s say you decide to sell one call option for Apple. For the sake of this example let’s use $210 as the strike price, which is one standard deviation from the current market price of the stock.
So the strike price is $210 and the expiry date is seven days from now. As soon as you sell the contract, you collect the premium paid by the buyer. Now, all you need to do is wait.
As long as Apple stock’s price stays below the strike price of $210, you get to keep your shares. The call option expires worthless and the buyer loses the premium.
What if the Underlying Stock Price Rises Above the Strike Price?
This is the most common question I receive when I talk about covered calls. In this situation, the current stock price of Apple rises above the strike price of $210. Now what? In the case that this happens you are, pardon the pun, covered!
If the stock price of Apple rises above $210, then the buyer of the contract can exercise it. This means that you would need to sell your 100 shares of Apple to the buyer, at the price of $210 per share.
If you’re doing the math, you have actually made more profit on the transaction. Of course, the contract buyer could also sell his contract for a premium, and your 100 shares may not ever be exercised. In this scenario, you make a profit and you can buy back your 100 shares of Apple.
Are Covered Call Options Risky?
Many traders I speak to have a preconceived notion that options trading is risky. Certain ways of trading options can be risky, but selling covered calls is a relatively safe options trading strategy.
It’s as close to a win-win situation as you can get. If the stock drops, you get to keep the premium received and your shares. However, the stock price rises, then your shares become more valuable, and you have a cushion between the current market price and your strike price.
Also, if the stock price continues to rise through the strike price, then you make a profit on selling your shares at the strike price. I know it’s not easy for new traders to accumulate 100 shares of a stock, but if you can afford it, then selling covered calls is a great way to make back some of that initial investment.
What are the Tax Implications for Writing Covered Calls
Remember that when you use covered calls, you generate additional income for your portfolio. Unless your covered call position is in a non-taxable account like an IRA or Roth IRA, then any extra income you make is subject to capital gains taxes.
You might find higher capital gains if you are forced to sell stock when the options contract is exercised. Normally if a stock price rises, you won’t have to pay capital gains taxes unless you sell your shares.
In the case of covered calls, you might be forced to sell your shares of the stock outright, so just be warned you could potentially incur unexpected capital gains!
How Much Can I Make From Covered Calls?
This is the real question, isn’t it? You’re not going to get rich overnight by selling covered calls.
It is a slow and steady process that requires very little time each week. Remember that you can generate income off of any stock you own 100 shares of. For the sake of another example, let’s say the premium you made when selling 100 shares of XYZ stock was $50.00.
That’s great! You have $50.00 in your account that you can allocate as you wish. Well let’s break this down even further: $50.00 is about $7.00 per day each week.
$7.00 x 365 days per year is $2,555.00 of upside profit potential. This is in the perfect situation where your options contracts never get exercised. On an initial investment of $10,000 that is an additional 25% you have made, plus any unrealized gains from a rise in the stock’s price.
Who Should Sell Covered Calls?
I get it, not everyone wants to trade options. For a lot of people, it is easier to just buy ETFs or other passive investments. But if you already have a long position in your portfolio, you might as well earn additional income by selling the call on it. Remember, everyone—including you and I—has the same investment objectives: to make a profit in the stock market.
Everyone Should Sell Covered Calls!
This is why I believe that the covered call strategy is viable for anyone who holds long positions in their account. All it takes is a few minutes to sell the covered call, and you have a steady income stream for as long as you own those 100 shares.
Keep in mind that depending on your brokerage, you might need to apply and get approved to begin trading options. Remember, even though it is lower risk, selling covered calls is still an options strategy. And we all know that options involve risk no matter how conservative you are!
What is the Downside of Covered Calls?
I already covered the risks with the covered call strategy earlier. There is always downside risk in investing. We are always just around the corner from another market crash!
The biggest loss you can sustain on your covered call is if you are already in the red on your underlying shares. If the 100 shares you own are already at a loss, then of course, if your call option gets exercised then you will incur a loss.
It’s important to take into account your cost basis and the risk of losing out on your initial investment before selling a covered call.
Conclusion: Covered Call Strategy
Is the covered call strategy for you? If you have the capital, I say yes, and here’s why! If you are an investor that holds long positions in your portfolio, the only gains you are making is potentially on dividends and capital gains.
But if you have the ability to trade options, covered calls are a great way to add an extra income stream to your account. Even though I do not trade covered calls myself, I truly believe they are an excellent, low-risk investment strategy that can benefit all of you!
For those who are long-term investors, selling covered calls is your ticket to earning extra capital on your existing investments. The best part is you can re-allocate this extra income to other stocks to continue to grow the value of your account!
Learn more about Markus Heitkoetter at Rockwell Trading.