Covered Calls: The Basics of Covered Call Strategy
With most things in life, it helps to be covered — by a coworker, an insurance policy, or a roof over your head. In investing, it can also pay to be covered. When it comes to options contracts, a covered call is an option trading strategy worth knowing about.
Here’s all you need to know about putting together a covered call strategy, when to consider it, and how it may — or may not — pay off.
What is a Covered Call?
A covered call is an options trading strategy that opens up an additional avenue to generate income. In a covered call transaction, an investor sells call options on a security they own. This strategy can be beneficial to the investor if they don’t expect the value of the stock price to move much in either direction during the terms of the option.
Call Options Recap
A “call” is a type of option (you may be familiar with calls versus puts), that allows investors to buy shares of an underlying asset or stock at a specific, prearranged price, called the strike price. Usually, an investor dealing with call options holds a long position — that is, they think that the underlying stock is going to appreciate.
This opens up the opportunity to profit from their position. If you thought that a stock’s price was going to increase, you might want to buy that stock, hold onto it, allow the price to increase, and then sell it in order to generate a profit.
Call options allow investors to do more or less the same thing, but without having to buy or pay the full price for the underlying shares. Instead, a premium is paid for the right to execute the trade at the strike price.
What’s the Difference Between a Call and a Covered Call?
The main difference between a regular call and a covered call is that a covered call is “covered” by an investor holding an actual position. That is, if an investor sells call options on Company X stock, it would be “covered” if the investor actually owns, or holds a position, on Company X stock.
Conversely, if an investor does not hold a position on, or own any Company X stock and sells a call option, they’re selling a regular call option. This is also known as a “naked” option.
Example of a Covered Call
The point of selling covered calls to other investors is to boost your own investment income. If, for example, you have 100 shares of Company X stock, and were looking for ways to potentially increase your annual return from that holding, you could try selling covered calls to other investors.
Here’s what that might look like in practice:
Your 100 shares of Company X stock are worth $50 each: $5,000 total, at current market value. To make a little extra money, you decide to sell call options to your friend Harris, at a strike price of $70. Harris pays you $10 for the premium.
Let’s say that Company X stock’s price only rises to $60, and Harris doesn’t execute the option, so it expires. You keep the $10, plus your 100 shares. You’ve turned a profit of $10 selling call options, and your shares have appreciated to a value of $6,000. So, you now have a total of $6,010.
For all intents and purposes, the best-case scenario, for you, is that your shares rise in value to near the strike price, (say, $69) but Harris doesn’t exercise the option. In that scenario, you still own your shares (now worth $6,900) and get the $10 premium Harris paid you.
But the risk of buying call options is that you could lose out on bigger potential gains.
So, if Company X stock rises to $90 and Harris executes his option, you would then be obligated to sell your 100 shares to him, which are now worth $9,000. You would still get the $10 premium, plus the value of the shares at the predetermined strike price of $70 — netting you $7,010. Effectively, you’ve turned a holding valued at $5,000 into $7,010. Not bad!
On the other hand, had Harris not exercised his option, your shares could be worth $9,000. That’s the risk you run when selling covered calls.
Recommended: How to Sell Options for Premium
When and Why Should You Do a Covered Call?
There is no definite right answer in terms of the right time to use a covered call strategy — it involves weighing the risks involved and doing a bit of reading the tea leaves in terms of the market environment.
It’s generally best to write covered calls when the market is expected to climb — or at least stay neutral. Nobody knows what’s going to happen in the future, and investors might want to be ready and willing to sell their holdings at the agreed strike price.
As for why an investor might use covered calls? The goal is to increase the income they see from their investment holdings. Another potential reason to use covered calls, for some investors, is to offset a portion of a stock’s price drop, if that were to occur.
Pros and Cons of Covered Calls
Using a covered call strategy can sound like a pretty sweet deal on its face. But as with everything, there are pros and cons to consider.
Covered Call Pros
The benefits of utilizing covered calls are pretty obvious.
• Investors can potentially pad their income by keeping the premiums they earn from selling the options contracts. Depending on how often they decide to issue those calls, this can lead to a bit of income several times per year.
• Investors can determine an adequate selling price for the stocks that they own. If the option is exercised, an investor profits from the sale (as well as the premium). And since the investor is receiving a premium, that can potentially help offset a potential decline in a stock’s price. So, there’s limited downside protection.
Covered Cons
There are also a few drawbacks to using a covered call strategy:
• Investors could miss out on potential profits if a stock’s price rises, and continues to rise, above the strike price. But that just goes with the territory. As does the possibility of an option holder executing the option, and an investor losing a stock that they wanted to keep.
• An investor can’t immediately sell their stocks if they’ve written a call option on it. This limits the investor’s market mobility, so to speak.
• Investors need to keep in mind that there could be capital gains taxes to pay.
The Takeaway
A covered call may be attractive to some investors as it’s an opportunity to try and make a little more profit off a trade. That said, as with all trading strategies, it may pay off in your favor, and it may not. There are no guarantees.
Calls, puts, and options trading can get complicated, and fast. That’s why it’s helpful if your options trading platform isn’t more complicated than it needs to be. SoFi’s options trading platform has an intuitive and approachable design. You can trade options from the mobile app or web platform, and reference the offered educational resources about options.
FAQ
There are a lot of details and terms regarding options, and it can be hard to keep track of everything. Here are a few common questions about covered calls.
Are covered calls free money?
Covered calls are not “free money”. But covered calls can provide a boost to one’s investment earnings — though an investor does have to assume some risks associated with selling options.
The strategy is more of a game of risk and reward, and there’s always the risk that the strategy could end up backfiring, particularly if your stock’s value increases much more than you anticipated.
Are covered calls profitable?
They have the potential to be profitable: If you’re selling call options on your holdings, then you should be receiving a premium in return. In that sense, you’ve turned a profit. After all, the entire point of selling calls on your holdings is to increase your profits, too.
But how profitable the strategy is, and the risks involved, will depend on a number of factors, such as the underlying stock, market conditions, and the specifics of the call option.
What happens when you let a covered call expire?
If you’ve sold a covered call option to someone else and it expires, nothing happens — you keep the premium, and nothing changes.
Because an option is only that — an option to execute a trade at a predetermined price for a select period of time — the option holder’s reluctance to execute during the time period means that the option will expire worthless.
Can you make a living selling covered calls?
Living strictly off of income derived from covered calls is theoretically possible, but you’d need a big portfolio (against which to sell those options) to make it work. There are a lot of things to consider, too, like the fact that a lot of the income your covered calls do generate is going to be taxed as capital gains, and that the market isn’t always going to be in a favorable environment for selling covered calls.
Photo credit: iStock/millann
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