In my 25 years of following the market, selling a covered call is one of my favorite things. It may not be one of the sexiest things to do, but it creates 100% passive income. You can make hundreds, if not thousands, of dollars every month on your investment portfolio.
For me personally, it actually helps lower my portfolio risk, while creating a financial gain. At the most basic level, this gain is manifested in one of the following ways:
- Rise in the stock price enabling you to sell and make capital gains
- Receive dividend earnings paid out by the stock
- A combination of price rise and dividend earnings
But there are other ways too. Like selling a covered call.
It requires you, the holder of shares, to sell a call option. When you sell a call option, the buyer of the contract gets the right to buy the stock at the strike price (or agreed price) till the agreed expiry date.
Just to refresh memory, an option is a contract that creates the right, not obligation, to buy or sell a stock at the agreed price, known as the strike price, till the agreed expiry date. The right to buy the underlying stock is known as a call option while the right to sell an underlying stock is a put option.
The strategy is termed ‘covered’ because the underlying stock on which the contract is written is already owned by you; hence you are not subject to the vagaries of market movements for owning it.
How do you sell a covered call?
How do you sell a covered call? The short answer is that you sell a call option on a stock you own. By selling a covered call, gives the holder the right to buy the stock at the strike price till a certain defined date. This transaction, the sale of the call option, generates a fee income for the seller, you.
As long as the ‘strike price’ stays above the market price, there is no reason for the holder to exercise the contract and it stays ‘out of money.’ If the market price stays below the ‘strike price’ till the expiry of the contract, it stays ‘out of money till the expiry date. This allows you to keep the entire amount received as commission as there is no further action or transaction that takes place.
If, however, the strike price does fall below the market price, and the option gets exercised, you will sell the shares that you already own, to the holder of the option, at the strike price. You don’t have any exposure to the market price of the share for fulfilling the contract.
Selling Covered Call Example
Now that you understand the basics of how to sell a covered call. We will now walk through selling a covered call step by step and illustrate with an example.
Step 1: You buy 100 shares of ABC Corporation at $100 per share. Your total outlay or investment is $10000.
You have purchased the stock obviously in the hope of a rise in its price. Let us assume you evaluate $120 as the target price over a 12-month horizon. This will give you a 20% return.
Step 2: The next step would be to look at the available options for that stock with the help of the company’s ‘options chain’ that lists all available options and select a call option strike price closest to your target price. Let us say it is $125. If the shares do get called, $125 is the strike price you will receive per share.
Step 3: Let us say that the $125 strike price for a 12-month call option on 100 shares of ABC Corp. has a bid price (buy price) of $500 and an ask price (sell price) of $600. When you sell the call option, you receive the bid price of $500.
Step 5: By selling the options contract, giving the buyer the right to buy the shares at the strike price of $125, you receive $500 in cash. This is your earning, regardless of what happens afterward.
Step 6: Two possibilities now exist:
1. The stock does not reach the strike price and the contract expires. You will retain the $500 you received as a result of selling the contract. So, you are better off than if you had done nothing and just retained the shares. You have received some income.
2. The stock reaches and exceeds the strike price and gets called. You will receive $12500 at the rate of $125 for 100 shares, giving you a total earning of $2500 for 100 shares. This is in addition to the $500 you received when you sold the options contract.
What just happened?
Selling covered calls enhanced your income through the premium on the option, without any sale or purchase of the underlying shares, creating what may be called ‘passive income’ for you. In addition, you could take advantage of price escalation by selling the shares for $125 each if the price rose beyond it. Moreover, since you already hold the stock, you are not exposed to the market to have to buy the stock in order to fulfil your obligation. So, in a way, a no-risk strategy.
So, if it is so easy to make more money, why isn’t everyone doing it?
There are always two sides to the story.
If the stock rises steeply before the option expiry, it is likely that the option will be called, limiting your upside to the strike price, with any excess over that going to the buyer of the options contract.
If you need to sell the underlying stock before the expiration of the options, you may need to buy back the contract which could impact your premium earnings and even convert it to a loss.
Like everything else in life and the stock market, the strategy has pros and cons. It is advisable to seek professional advice to understand the strategy and its pros and cons prior to selling calls.
Want to learn more about covered calls? Check out my course here. I give you my “secret” formula that I personal use to sell covered calls.