A covered call technique is a method of investing that involves selling call options. It’s the right to buy stock from which you already earn money or have recently purchased to increase your earnings. Because you own enough shares to cover the transaction as required by the option you’ve sold, the option you’re selling is “covered.”
A covered call strategy can help investors earn money while also restricting their potential earnings from a stock’s price increase. Learn how a covered call approach works and whether you should try it out.
A covered call is a type of option strategy in which an investor sells call options against stock they already own or have acquired for the express purpose of doing so. You’re giving the buyer of the call option the right to purchase the underlying shares at a fixed price and date by selling the call option.
Because you already own the stock that will be sold to the buyer of the call option when they exercise it, this approach is “covered.”
There are two steps to a covered call strategy:
The first step is to purchase shares of stock. You may choose the stock in any way that works for you. It’s critical to do your research, as with any investment. Covered call trading strategies are effective with stocks that have consistent pricing and aren’t prone to big swings.
Second, you sell call options against the stock you’ve acquired. The buyer of a call option has the right, but not the obligation, to acquire shares at a certain price.
When you sell an option, the buyer must pay you a premium; therefore, when the option expires, you keep the premium as income. Each option contract is for 100 shares.
A popular options trading strategy is a covered call technique. It’s often considered low-risk compared to others. It may help you make money with your portfolio. Even in accounts that aren’t allowed to trade other options, many brokerages will allow the sale of covered calls.
The fact that you can only lose a certain amount of money with covered calls is what makes them seem low-risk. You may be exposed to theoretically infinite risk with some other options contracts.
Henry Gorecki told The Balance “Covered calls can be a great source of income, but you should always be ready to lose the underlying stock. Think twice about writing calls on the stock of a great, growing company that you may want to hold on to for long-term appreciation.”
You’re not only protecting yourself from financial loss by employing a covered call approach. You’re also limiting how much money you could make as the stock’s price rises. In return, you receive premium income in the form of the option buyer’s premium payment.
Michael buys 100 shares at $20 each with a total value of $2,000. Expecting the share price to rise, Michael sells an options contract at strike price $25 to Lyn. Lyn pays a premium of $10 for the call option.
If the share price doesn’t go above $25, Lyn will most likely not exercise the option, so it expires worthless for him. Michael keeps his shares and keeps the $10 that Lyn paid for the call option.
The total profit or loss for Michael is $10, plus or minus the change in the price of the stocks he bought at $20 per share.
The best-case scenario for Michael is if before the option expires, the stock’s price goes up to exactly $25 but Lyn didn’t exercise the option.
In this scenario, Michael keeps the $10 he received from Lyn and the shares he originally bought. Which are now worth $2,500 because of the stock price rise. Combining the stock price rise with the $10 premium he received from Lyn, Michael’s total profit is $510.
For Michael, the worst-case scenario would be if his shares become worthless. When that happens, Michael loses his initial investment of $2,000 but gets to keep the $10 Lyn paid him. Putting Michael at a loss of $1,990.
The shares would become worthless if the company goes bankrupt and they aren’t worth anything anymore.
If before the option expires the price of the shares Michael bought go up to $35, Lyn can exercise the call option he bought. Lyn pays Michael $25 per share. Michael keeps the $10 premium he received from Lyn and receives $2,500 from Lyn for the 100 shares.
Michael’s overall profit in this scenario would be $2,510. But Michael loses on potential profits because he sold his shares for $25, when he could have sold them for $35. Michael could have made $3,500 instead of $2,500.
But the call option Michael sold (at strike price $25) to Lyn forces Michael to sell them for $25 regardless of how high the price of the stock is before expiration.
Michael made this choice expecting that the price of the stock would not go above $25, or at least not too much so he either keeps his shares and receives a premium, or doesn’t lose out on high potential profits.
When you invest in a company, you are taking the risk that its value may decrease. As the stock’s price rises, so do your investment’s value. While trading in covered calls is straightforward, selling one may be more profitable in some cases.
The below table shows how your investment gets impacted by stock price changes when you own a stock, compared with when you sell a covered call.
Own the stock and the price goes up: your profit equals the increase of the stock price times the number of shares you own.
Covered call and the price goes up: your profit only goes up to the strike price that you sold the stock (in example above $25) plus the premium you received. You forgo any future potential profits. The profit of the stock going up until the strike price plus the premium will be less than what you would’ve made if you had sold the stock for the highest price it went up to.
In this case that the stock goes up by a lot, it’s more profitable to own the stock rather than sell a covered call.
Own the stock and the price goes up but below strike price: your profit equals the increase of the stock price times the number of shares you own.
Covered call and the price goes up but below strike price: your profit equals the increase in stock price plus the premium you received. With the premium received you made more money than if you only owned the stock.
In this case when the stock price goes up but below the strike price it’s more profitable to sell a covered call.
Own the stock but no price change: you don’t have any profits or losses.
Covered call but no price change: your profit is the premium you received.
The covered call is a better strategy when there is no price change.
Own the stock but price decreases: your loss is equal to the decrease in price of the stock.
Covered call but price decreases: your loss is equal to the decrease in price of the stock minus the premium received.
The covered call is a better strategy when there is a price decrease because the premium received minimizes your losses.
One disadvantage of trading covered calls is taxes. It might be a significant limitation for some people.
Gorecki says “Net gains and losses on covered calls are short-term capital gains and losses, short-term capital gains are taxed like ordinary income.”
This means you could end up paying more in taxes than you would if long-term capital gains were taxed at your marginal rate. But it’s not as simple as that.
The Options Clearing Corporation (OCC), the options market’s clearing agency, assigns exercises notifications to trading firms with equivalent option positions after an option is exercised. This is referred to as “assignment.”
When you sell an option, the difference between the strike price and the premium received is referred to as a “premium.” If you’re referring to gains or losses in general, they’re called “short-term capital gains or losses.”
When you sell an option, it’s possible that long-term capital gains or losses will be incurred if your stock appreciation isn’t marked by time decay (i.e., when the value of money grows).
Covered calls are a popular approach for long-term investors to boost their portfolios’ income.
The key to success with covered call tactics is to select the appropriate stock to sell the option on. Then, pick the proper strike price.
A straightforward covered call is the most effective when the price of the stock remains below the contract’s strike price. It also offers a modest degree of protection against significant losses, since you can not lose money gained from selling an option.
The main hazard of the approach is that you lose out on gains if the value of your assets rises too swiftly.
Covered calls are a good place to start if you’re ready to dip your toes into options trading. Selling a covered call may sometimes be more profitable than holding the stock. However, options trading is not for everyone. Before making any decisions, consider how much risk you can handle.
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