In my 25 years of following the market, selling covered calls for income is one of my favorite things. It may not be one of the sexiest things to do, but it creates income. Will a good covered call strategy, you can make hundreds, if not thousands, of dollars every month on your investment portfolio. The other exciting thing is that trading options when you are the seller, they are not very risky.
For me personally, adding the options income helps lower my portfolio risk, while creating income and financial gain. By selling call options, your gain is manifested in one of the following ways:
- The rise in the underlying stock price enabling you to sell and make capital gains.
- You can also receive dividend earnings paid out by the stock.
These are just two reasons why like selling a covered call. It can also help with retirement planning and personal finance goals. Although the income is created instantly, I highly recommend this strategy be used as part of a long-term goal.
A covered call requires you, the holder of shares of stock, 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.
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Just to refresh your 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, 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 covered call 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? 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” plus premium 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” 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 is long-term strategy and should not be used as a “get rich quick” plan. The goal is to keep the stock position and the income. Selling too expensive calls will cause the stock to be exercised.
- 1 Selling Covered Call Example
- 2 How much money can you make selling covered calls?
- 3 Is selling covered calls profitable?
- 4 How do I make a monthly income from covered calls?
- 5 Who decides the Strike Price?
- 6 Can covered calls make you rich?
- 7 Can you lose money on a covered call?
- 8 What is a poor man’s covered call?
- 9 What is the downside of selling covered calls?
- 10 Why covered calls are bad?
- 11 What is the risk in selling covered calls?
- 12 Is it better to sell weekly or monthly covered calls?
- 13 What is the difference between a call and a covered call?
- 14 Can you sell a call option early?
- 15 What happens when a covered call expires worthless?
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 value you will receive per share.
Step 3: Let us say that the $125 strike 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 a bid price of $500.
Step 5: By selling the options contract, giving the buyer the option 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 plus premium 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?
Covered Call writing enhanced your income through the premium on the option, without any sale or purchase of the underlying shares, creating or generate 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 underlying security, you are not exposed to the market to have to buy the stock in order to fulfill your obligation. So, in a way, a no-risk options 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 option buyer.
If you need to sell the underlying security 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. A sudden rise in stock price caused by the news is often the cause for investors to buy back calls. This is done because the goal is to keep the stock to write calls for long-term income.
Like everything else in life and the market, the options strategy has pros and cons. It is advisable to seek professional advice to understand the strategy and its pros and cons prior to selling call options. Options trading can be very complicated to understand.
Want to learn more about covered calls, how to generate income, and get to keep your stock? Check out my course here. I give you my “secret” covered call strategy that I personally use to sell covered calls.
How much money can you make selling covered calls?
Investors can make from 0.3% to 3% or more selling covered calls. How much you earn depends on the volatility of the underlying security, the strike price to the underlying security’s trading price, and the time frame. Most investors are trying to hold onto the stock position while selling calls for income so they often set a shorter time frame and high strike price. If an investor wanted to maximize the income, he would select strike prices close to the stock’s trading price.
Is selling covered calls profitable?
Selling covered calls are profitable and also helps hedge a downturn in the stock market. You need to determine your risk tolerances and set the right expectations in order to gauge whether or not this strategy is a good fit for you.
Just like the market, there are periods of time when selling covered calls is profitable and other times when it’s not.
How do I make a monthly income from covered calls?
First, you purchase a stock position of 100 shares. Then, you sell 30-day call options against that stock so that you collect income from the option premium. This is how you generate or make your money. If the stock price doesn’t move above the strike price of the call option, your downside risk is limited to the money you received for selling that option.
And if your prediction about the stock price is wrong and it rises above your original purchase price, then you could lose money – even though you still own it.
That’s why selling covered calls work better with stocks that are undervalued or cheap compared to their true value.
Who decides the Strike Price?
A common question I get is on the strike price and who determines it. The short answer is that the strike price is determined by the exchange automatically based on the securities price movements. Both the seller and buyer can decide which strike price they want to buy or sell the security.
Can covered calls make you rich?
Selling covered calls is a viable strategy. Many covered call sellers make money. But it’s not for everyone. First, you need to have the capital to buy the stocks. This can be substantial if the stock price is expensive because you need to own 100 shares of the underlying asset for 1 option. An expensive stock is Amazon (AMZN) which is around $3000 per share.
You would need to buy 100 shares ($3000) for just one covered call. Fortunately, there are many stocks below $10 that you can also buy. The second thing is you need to constantly hold on to your stock and maximize the income. During this time you need to make sure your stock doesn’t drop in price or increase too much in price.
Can you lose money on a covered call?
You can’s lose money on selling a covered call option, however, if the stock price drops below your purchase price of the underlying asset for the covered call you can lose money. Losses will occur when the stock drops below the purchase price minus the option premium paid.
Investors with dividend stocks should be cautious about selling covered calls around ex dividend dates because their contracts can be exercised for the dividend. The ex dividend date is when the owner is credited to receive a future dividend.
What is a poor man’s covered call?
A “Poor Man’s Covered Call” is not a technically a covered call but rather a Long Call Diagonal Debit Spread that is used as a similar strategy as a Covered Call position. The poor man’s covered call is so named because it greatly reduces the capital requirement and risk when compared to a standard covered call.
What is the downside of selling covered calls?
The two downsides of selling covered calls are the loss of upside potential if the stock moves past the strike price and premium and the second is the risk of the stock losing value.
Why covered calls are bad?
The primary problem with covered calls is the requirement to own the stock that you are selling covered calls because the stock could drop in value. If the stock drops too much in value, you will not be able to sell calls at a price that would be profitable.
What is the risk in selling covered calls?
There are two risks in selling covered calls. The first that you sell a covered call and the stock price moves above the strike price and premium and the option is exercised. You lose out on the full gain of the stock. The second risk is that the underlying asset drops below your purchase price minus the premium paid and you lose money. If it is a dividend stock, the contract could be exercised around the ex dividend date and you will lose the dividend.
Is it better to sell weekly or monthly covered calls?
It is better to sell covered calls monthly if you are looking to generate income. Sells calls that are out of the money to avoid the risk of being exercised. Many stocks do not offer weekly options and it can be a bit overwhelming to keep selling calls every week.
What is the difference between a call and a covered call?
A call is the right to buy a stock or ETF. Selling a covered call is when you give someone else the right to purchase your stock or ETF.
Can you sell a call option early?
Investors can close a covered call early by buying a call with the same strike price and date. Options trading is very volatile, so it is best to take your time and set limits on your orders.
What happens when a covered call expires worthless?
When a covered call expires worthless you get to keep the premium paid to you. It is that simple. Once the option has passed the expiration date, your obligation is gone and you get to keep the premium received.