Options can seem scary at first glance with new terms to learn, such as puts, calls, theta, gamma, delta and implied volatility. Unlike stock trading strategies that are generally straightforward, options trading strategies can be more complex. Calls and puts can be bought and sold, and combined to form a variety of options trading strategies that align with your view of financial markets.
Of all the available options trading strategies, perhaps the most powerful and the one worth mastering is the covered call strategy.
How To Generate Income: The Covered Call
Of the numerous options trading strategies available, the covered call strategy is among the simplest and most powerful. Covered call traders can generate income regularly without relying on dividends, specify when income is generated (weekly, monthly, quarterly, and yearly), and lower cost basis compared to holding stock alone.
Perhaps the most powerful of all options trading strategies is the covered call strategy. Many buy-and-hold stock market investors miss out on the regular income potential covered call options strategies provide but by spending some time learning the covered call strategy, you can discover how to generate income and lower cost basis more effectively than could otherwise be done by investing only in stocks.
To understand how effective the covered call strategy is at producing income, consider a comparable income-producing opportunity, an investment property. Few real estate investors would buy a second home and leave it vacant without renting to a tenant.
If they did, they would make money only when the home appreciated in value. Instead, real estate investors rent out property to tenants in order to receive a monthly rent.
Although it seems obvious to generate rental income when owning a rental property, few stock investors proactively generate income from their stock holdings – though investors holding dividend-paying stocks enjoy income when the company issues dividends.
When a company pays dividends, investors receive regular dividend payments according to the schedule set by the company, not the investor.
So how do you generate income according to your own schedule from stocks you already own or plan to purchase? A simple way is via the covered call strategy, which allows you to create a regular income stream and lower cost basis compared to owning stock alone.
Covered Call Basics
Each time you sell a call option you get paid an amount, the call option premium, which lowers the cost basis and risk compared to owning stock alone. The positive aspect of owning stock with no call option(s) sold against it is the share price of the stock has theoretically unlimited upside potential while a covered call options trading strategy has limited reward potential.
The covered call strategy is one of the most powerful options trading strategies and also one of the simplest.
It involves selling call options against a stock holding. For every 100 shares of stock held, 1 call contract is typically sold – because 1 option contract usually corresponds to 100 shares of stock.
Each call option sold creates an obligation, which is to sell the underlying stock at some pre-agreed price in the future if the stock rises to that level.
Now imagine you own 100 shares of a stock, which is trading at $45 per share, and would like to generate some additional income – other than what may be paid in dividends.
A way to achieve your goal would be to sell a call option against the shares of stock you own. For example, you could sell what is labeled as a strike 50 call option which obligates you to sell your stock at $50 per share by some specific date in the future.
At first glance, you might surmise that it makes little sense to agree to sell your stock at a fixed price in the future. After all, what if the stock soared higher to say $60 before the specified date?
As it turns out, your concern has merit because if you initially sold a strike 50 call and thereafter the stock soared to $60, you would still have had to sell your stock at $50 per share.
So, you would have missed out on most of the share price appreciation as the stock climbed higher from $50 to $60. Knowing that selling a call option can result in significant opportunity cost, what makes the covered call one of the best options trading strategies?
The short answer is every time you sell a call option you get paid.
Plus, on most optionable stocks, you can get paid on a frequency schedule that you prefer: weekly, monthly, quarterly and even yearly.
In exchange for selling a call option at strike $50 and agreeing to sell your stock at that price, you get paid a call option premium.
To keep the calculations simple, let’s say you get paid $1 per contract over the next month for selling the call option. That translates to $100 of option premium that you get to pocket, excluding transaction costs.
The reason the covered call options strategy is so effective in generating income is that you get to sell call options on an ongoing basis, for example this month, next month and the month after. And every time you do so, the overall cost basis of the combined stock and options position decreases.Advertisement
How To Lower Cost Basis and Risk
Over time, selling call options consistently lowers risk and cost basis compared to holding stock alone as part of a buy-and-hold strategy.
The simplest way to understand how the covered call strategy lowers cost basis and risk is to compare the risk of holding a covered call position with the risk of holding only stock.
In the example above, the worst case outcome when holding only stock would be realized if the stock were to fall all the way to zero: a full $45 per share would be lost. Although this outcome is unlikely, the example will highlight how the risk of a covered call position is lower than the risk of holding stock alone.
By selling a call option for $1 per contract against that same stock holding as part of a covered call strategy, the risk is reduced from $45 to $44 per share.
So, in the same worst case situation when the stock falls to zero, the risk is reduced from $45 per share to $44. Perhaps that doesn’t seem too attractive at first glance, but over time the benefits of lowering risk regularly by selling call options against a stock holding are obvious.
Selling the call option reduced the risk by $1 in a specific time period. By repeating that strategy and selling another call option in the next time period, perhaps the risk could be lowered by an additional $1.
And in the time period after that, yet another $1 could be captured when selling a further call option. Quickly you can see that if $1 of option premium could be captured in each time period, then in 45 time periods, the sum of the call option premiums add up to $45, which is the share price today.
The downside is it takes a while to execute this strategy of selling calls to continually lower risk compared to holding stock alone. Although it is a slow and steady approach to generating income, the covered call strategy can be highly effective over time because in each time period risk is reduced compared to just holding stock.
Why The Covered Call Is A Powerful Options Trading Strategy
Unlike a buy-and-hold investor who receives cash flow from dividends according to the schedule set by the company, a covered call trader can generate cash flow from selling call premiums on a more regular basis, such as weekly, monthly, quarterly and yearly.
The benefits of the covered call options strategy are obvious when compared to holding stock alone. Contrast holding a stock as part of a buy-and-hold strategy with selling call options against stock you own.
If you ask yourself by how much the share price can increase as part of a buy-and-hold strategy, you might estimate that it can increase by say 10% or 50% or 100%.
In the example above, a 100% gain in the share price would result in a price increase from $45 to $90. As high as the share price might rise, what is certain is that the share price will not increase forever.
However, you can sell call options against the stock theoretically forever, or at least as long as you own the stock and options are traded on it.
So, while the buy-and-hold investor must rely on dividends for income and stock appreciation to make money, the covered call trader can sell call options regularly to generate income without relying on dividends and can make money even when the stock doesn’t rise higher.
If the stock doesn’t reach the call option’s strike price of $50 in the example above, the call expires and the seller gets to keep the premium of $1. And then the covered call trader gets to repeat that process again and again.
Why Doesn’t Every Stock Trader Sell Covered Calls?
A buy-and-hold strategy might lead to higher profits than a covered call strategy if the same stock purchased in both cases were to soar higher after entering the covered call, but over time the premiums from selling call options can add up to a substantial amount and may eclipse the gains from holding stock alone. Investors who are focused on the short-term may miss out on the accumulated benefits gained when selling calls regularly.
You might be tempted to ask the question “if covered calls are so good, why doesn’t every stock investor choose to sell calls against their stock positions as part of a covered call strategy?”
First of all, not everyone is aware of options trading basics, such as the covered call options trading strategy. And many stock market traders who are aware of the covered call strategy often don’t have the patience or inclination to execute the strategy regularly.
Some worry about missing out on share appreciation if they sell call options against their stock holdings. They ask “what if” questions. For example, “what if the stock rises above the call strike price and I have to sell my stock?”
The downside of selling call options is from time to time it will seem like a bad deal. If you purchased the stock at $45 per share, sold a call at strike $50 and thereafter the stock rose to $60, you would be understandably upset to have missed out on the $10 of stock appreciation from $50 to $60 (you did enjoy the share price gains from $45 to $50, the call strike price, but thereafter you missed out on further share appreciation as the sale of the strike 50 call option limited your upside by obligating you to sell your stock at $50).
To stay focused on the bigger picture, keep in mind that the times when a stock rises fast and far are not the norm – no stock rises aggressively forever.
Although you will get the raw end of the deal from time to time when selling call options against purchased stock holdings, the covered call strategy will seem like a good deal more often than not.
If stocks generally meander, then more often than not it makes sense to take advantage of an options trading strategy that wins at such times.
Even if some gains are missed when a stock soars higher, consistent application of the covered call strategy has the potential to produce sizeable gains over time. Because the benefits of the covered call options strategy are especially evident over the long-term not every trader has the patience for it, but those who do are generally rewarded for it
How To Calculate Covered Call Risk & Reward
The risk in a covered call strategy is calculated as the maximum amount you can lose, which is the cost of the stock minus the premium received when selling the call option(s). The upside is capped at the strike price at which the call options are sold. The maximum profit potential is the difference between the call strike price and the cost basis, which is the cost of the stock minus the amount received when selling the call option(s).
The maximum risk in a covered call strategy is the cost of buying the stock minus the premium received selling the call option(s):
Stock Price: $45
Strike 50 Call: $1
Cost Basis = Stock Price – Call Premium = $45 – $1 = $44
The best case outcome is realized when both the call option and the stock make money. If the stock were to rise to $50 or above, a profit of $5 is enjoyed on the stock (when it rises from $45 to $50) and $1 of profit is generated from the call option.
Best Case Profit = Call Strike Price – Cost Basis = $50 – $44 = $6
No matter how high the stock goes, the best case profit is the most that can be made trading a covered call strategy.
While most novice investors might understandably feel remorse if the stock were to rise above $50 before the option expired, thereby obligating them to sell the underlying stock at $50, the experienced investor will likely be pleased when calculating the rate of return (the % profit made in the time period the trade was held).
For example, if you could make $6 of profit on a cost basis of $44, that would translate to a 13.6% return on risk. If you could generate that return on risk in two months, your annualized return (the return you would enjoy if you could replicate that percentage return every 2 months for a full year – a theoretical figure but valuable to illustrate the point) would be a whopping 81.6%!
Most experienced stock market investors recognize such returns are generally out of reach over a long time period, so enjoying such a handsome rate of return over the short term is a cause for celebration not remorse. Many sophisticated investors would be pleased to earn a 13.6% return in a year let alone in two months. So, locking in such a large gain in such a short time period is not to be sneezed at.
Best Covered Call Brokers
To place a covered call trade, you will need a broker who understands options trading strategies. Most brokers do a good job catering to traders who wish to trade covered calls because the risks and rewards in covered call strategies are well defined and easily calculated.
Some other options strategies are more complex, making it more difficult for brokers to calculate and manage risk.
As a result, brokers who are not so sophisticated when it comes to calculating risk on complex options trading strategies will shy away from supporting these more advanced trade types.
Among the best online options trading platforms are thinkorswim and tastyworks. All three of these platforms were founded by options traders who have a deep understanding of the risks and rewards associated with simple and complex options trading strategies.
The Truth About Naked Calls
When selling call options without simultaneously owning stock (to cover the obligation to sell stock), a naked call position is opened, which has theoretically unlimited loss potential. This is considered a highly risky strategy, and generally only appropriate for sophisticated traders with extensive capital reserves.
Although covered calls are among the most powerful and simple of stock and options trading strategies, they are not without risk if applied incorrectly. For example, if you own 100 shares of stock and sell 2 contracts, only one call is “covered”, the other is considered naked!
Entering naked call option trades is generally not an options trading strategy that a novice trader should pursue because the risk of so doing is theoretically unlimited.
For example, if you bought 100 shares of stock at a price of $45 per share and sold 2 call contracts at strike 50, then for each call contract you sold, you are obligated to sell 100 shares of stock at $50, no matter how high the share price goes.
To highlight the danger of trading naked calls, imagine the share price rising all the way to $100 per share. For the first call contract, this share price appreciation is no problem because you bought the stock at a price of $45 so you can fulfill your obligation to sell the stock at $50 per share.
But what about the other call option contract?
With the stock at $100 per share, you still have an obligation to sell an additional 100 shares of stock at $50. But you don’t own sufficient stock to meet your obligation, which is to sell shares at $50.
Because you have fulfilled your obligation to sell the first 100 shares of stock but still need to fulfill your obligation to sell an additional 100 shares, which you don’t own, you will need to buy 100 shares in the market in order to sell them back for $50!
Quickly, you can see how this is a dangerous situation to find yourself in because you need to buy stock at whatever price it is trading in the market – $100 in this case – in order to sell it as obliged at the agreed upon strike price, which is $50 in this example.
So by selling one covered call contract and one naked call contract, you end up with a handsome profit on the covered call position as the stock soared but a big loss on the uncovered or naked call contract.
In this case, the loss on the stock relating to the uncovered call is $50. Even if you got to keep $1 when selling the call initially, it doesn’t come close to offsetting the loss incurred from the stock.
Because the stock can theoretically rise without limit, causing ever more risk and loss, a naked call contract is generally discouraged for all but the most sophisticated and well-capitalized of investors.
How Covered Calls Can Increase Retirement Income
In 401(k) and IRA retirement accounts, taxes do not need to be paid until your retirement years so gains from covered calls grow on a tax-deferred basis and you don’t have to worry about paying capital gains tax when stock is sold.
In a non-retirement account, the risk of selling call options and being forced to sell stock at the agreed upon strike price is that a taxable event is triggered. When the stock is sold, taxes (short-term or long-term capital gains taxes) must be paid on realized stock profits.
In a retirement account, such as a 401(k) or traditional IRA, no taxes need to be paid until distributions are made in your retirement years so the risks of paying taxes when call options are assigned and stock is sold is not a factor you need to worry about.