What is a covered call?
A covered call option is another basic option strategy that aims to provide small but consistent income while owning a stock. It should be used in cases where you are okay with selling your stock at some point, but not in a rush to do so. This usually means you have a somewhat bullish to neutral outlook on the stock.
To utilize this strategy, you should already own 100 shares of the underlying stock, or begin by purchasing 100 shares if you don't already have them. Then, you sell a call (known as a short call) at your desired strike price. This is the opposite of buying a call, and results in a credit to your account rather than a debit.
If the stock price rises above the strike price, your call will be assigned you will be forced to sell 100 shares. (Remember that the owner of the call is able to exercise the call to buy 100 shares - you are on the other end of the process). Since the strike price is ideally above the price you purchased the shares for, you will profit off the stock and the premium earned from selling the call.
If the stock doesn't expire above your strike price, you simply keep the premium (or credit) earned from selling the call. Remember how easy it is to buy a call and have it expire worthless? This is the opposite case, where you want the call to expire worthless so that you can collect the premium.
You can earn a steady "rent" from selling the calls by repeating this process every month or every few months depending on how far out the expiration is. If you are assigned at some point, the cycle doesn't have to end there! There is another strategy called "The Wheel" which combines selling covered calls and cash-secured puts to create a constant income cycle.
- Own or buy at least 100 shares of a stock. Each option contract is generally for 100 shares, so if you want to sell 3 calls you'd need 300 shares.
- Sell a call that is slightly out of the money. If it is too far out-of-the-money, then the credit received will be very insignificant as you are taking on little risk. Likewise, a strike that is closer to being at-the-money will net a larger credit as there is a high chance you will be assigned and lose your stock. The strike you choose is dependent on how eager you are to get rid of your stock, at what price you'd be comfortable selling it at, and how much risk you are willing to take on for the premium. When selling the call, you should be placing a "sell to open" order.
- The above steps can be done at the same time, which is known as a "buy-write" because you are buying stock and writing an options contract together.
The goal for a covered call depends on your risk-tolerance and outlook for the stock, but you should be comfortable with either scenario happening:
- If you are confident in your bullish outlook on the stock, you may want to choose a strike that is further out of the money. The goal is to make consistent income by selling calls, without losing your stock. In this case, you want the stock to stay the same or go up a bit, but not go above your strike.
- If you are ready to get rid of your stock (for a profit), you can choose a strike that is not as far out of the money. This will net a greater credit as there is a greater chance that you will be assigned. The goal is to be assigned, selling your stock at the strike price for a profit.
- By selling covered calls on fixed schedule (perhaps every 30 to 45 days), you can make consistent income every period. This credit is yours to keep, whether or not you are assigned. (Unless you roll or close the call early)
- Your cost basis for the stock is lowered due to the credit you receive from selling the call. By lowering your cost basis over time, you will have a higher probability of making a profit off the stock. For example, if you buy 100 shares at $50 per share and sell a call for $1.50, your cost basis can now be thought of as $48.50 per share.
- If the stock rises above your strike (meaning you will get assigned, and be forced to sell) and you change your mind about selling it, you may not be able to cheaply exit out of the trade early due to the cost of buying back the call.
- If the stock rises above your strike plus the option premium, you are then missing out on profit that you would otherwise earn if you only owned the stock. (Since you area forced to sell at the strike price, rather than the market price which is now higher)
- Getting into covered calls can be expensive, since you need 100 shares of the stock. Other strategies require much less capital. The income (credit) you receive is also very small compared to the amount tied up in owning the shares.
- Be aware of major events that will affect the stock, such as earnings announcements or guidance. If you are selling covered calls every month for a bit of income, you may want to skip this strategy during such events as there is a high likelihood that a large move could get you assigned. On the contrary, you could make a much larger credit if you are willing to take such a risk, since the premiums will be larger as IV is elevated. If you notice that the premium is considerably higher than normal, check the news for any upcoming events that are causing options for the stock to be in higher demand.
- If you'd like more time or want to change the strike, you can roll the call into a new call of a different strike and/or expiration. This is just a fancy way of saying: close the existing call (by buying it back) and sell a new call. If you are considering rolling, it's usually because the trade is not going your way already. The call is most likely worth more than it was when you sold it to open, so you will have to close the call at a loss. The premium from the selling the new call can be used to offset it, but ultimately you are reducing the credit you initially received. (Rolling is not a free way to get more time, as some people may suggest)
- Remember that assignment rarely happens before expiration. The stock can go above the strike without you being assigned before expiration, because there is still time value left on the option and it wouldn't make sense for the owner to exercise it.
- While covered calls are a neutral to bullish strategy, you should have a plan for what happens if the stock goes down. If you are okay with it going down, no action is needed. If you would like to sell the stock however, you will also need to close out the call (otherwise it wouldn't be "covered" anymore). The good news is that the call will likely be worth less, since the stock dropped in value, so you can still close it out and keep some of your credit.
The breakeven for the covered call strategy is very simple. Since you own the stock and get a credit from the call, the breakeven price of the stock is lowered by the credit amount.
breakeven = stock price - option premium
The maximum profit is the difference between the purchase price of the stock and the selling price (which is the strike), plus the premium received for selling the call.
max profit = strike price - stock price + option premium
(Stock price here meaning the price you bought the stock at, not the current price)