If you’re looking for an options strategy that provides the ability to produce income but may be less risky than simply buying dividend-paying stocks, you might want to consider selling covered calls. As long as you’re aware of the potential risks—including transaction costs as well as any tax and wash sale implications—this basic strategy is designed to help generate income from stocks you already own.
Understanding covered calls
As you may know, there are only two types of options: calls and puts.
Calls: The buyer of a call has the right to buy the underlying stock at a set price until the option contract expires.
Puts: The buyer of a put has the right to sell the underlying stock at a set price until the contract expires.
Although there are many different options strategies, all are based on the buying and selling of calls and puts.
When you sell a covered call, also known as writing a call, you already own shares of the underlying stock and you are selling someone the right, but not the obligation, to buy that stock at a set price until the option expires—and the price won’t change no matter which way the market goes.1 If you didn’t own the stock, it would be known as a naked call—a much riskier proposition.
Why would you want to sell the rights to your stock? Because you receive cash for selling the option (also known as the premium).
For some people, receiving extra income on stocks they already own sounds too good to be true, but like any options strategy, there are risks as well as benefits.
How this strategy works
Before you make your first trade, it’s essential that you understand how a covered call strategy works. So, let's look at a hypothetical example. Let’s say in February you already own 100 shares of XYZ, which is currently trading at $30 a share. You decide to sell (a.k.a., write) one call, which covers 100 shares of stock (If you owned 200 shares of XYZ, you could sell two calls, and so on).
The strike price
You agreed to sell those 100 shares at an agreed-upon price, known as the strike price. When you look up the options quotes, you’ll see an assortment of strike prices. The strike price you choose is one determinant of how much premium you receive for selling the option. With covered calls, for a given stock, the higher the strike price is over the stock price, the less valuable the option.
Therefore, an option with a $32 strike price is more valuable than an option with a $35 strike price. Why? Because it is more likely for XYZ to reach $32 than it is for it to reach $35, and therefore more likely that the buyer of the call will make money. Because of that, the premium is higher.
The expiration date
In addition to deciding on the most appropriate strike price, you also have a choice of an expiration date, which is the third Friday of the expiration month. For example, let’s say in February you choose a March expiration date. On the third Friday in March, trading on the option ends and it expires. Either your option is assigned and the stock is sold at the strike price or you keep the stock. Because some don't want to be in this trade for too long, they may choose expiration dates that are only a month or two away. Hint: The further away the expiration date, the more valuable the option because a longer time span gives the underlying stock more opportunity to reach the option's strike price.
Note: It takes experience to find strike prices and expiration dates that work for you. Inexperienced options investor may want to practice trade using different options contract, strike prices, and expiration dates.
Your first covered call trade
Now that you have a general idea of how this strategy works, let’s look at more specific examples. Remember, however, that before placing a trade, you must be approved for an options account. Contact your Fidelity representative if you have questions.
- In February, you own 100 shares of XYZ, which is currently trading at $30 a share.
- You sell one covered call with a strike price of $33 and an expiration date of March. The bid price (the premium) for this option is $1.25.
- Suppose you then said to yourself: “I’d like to sell one covered call for XYZ March 33 for a limit price of $1.25 good for the day only.” Hint: It’s suggested you place a limit order, not a market order, so that you can specify the minimum price at which you would be willing to sell.
- If the call is sold at $1.25, the premium you receive is $125 (100 shares x $1.25) less commission.
- Now that you sold your first covered call, you simply monitor the underlying stock until the March expiration date.
Let’s take a look at what could go right, or wrong, with this transaction.
Scenario one: The underlying stock, XYZ, is above the $33 strike price on the expiration date.
If the underlying stock rises above the strike price any time before expiration, even by a penny, the stock will most likely be “called away” from you. In options terminology, this means you are assigned an exercise notice. You are obligated to sell the stock at the strike price (at $33 in this example). If you sell covered calls, you should plan to have your stock sold. Fortunately, after it’s sold, you can always buy the stock back and sell covered calls on it the following month.
One of the criticisms of selling covered calls is there is limited gain. In other words, if XYZ suddenly zoomed to $37 a share at expiration, the stock would still be sold at $33 (the strike price). You would not participate in the gains past the strike price. If you are looking to make relatively big gains in a short period of time, then selling covered calls may not be an ideal strategy.
Benefit: You keep the premium, stock gains up to the strike price, and accrued dividends.
Risk: You lose out on potential gains past the strike price. In addition, your stock is tied up until the expiration date.
Hint: Choose from your existing underlying stocks on which you are slightly bullish long term but not short term, and are not expected to be too volatile until the option expires.
Scenario two: The underlying stock is below the strike price on the expiration date.
If the underlying stock is below $33 a share (the strike price) at all times before expiration, the option expires unexercised and you keep the stock and the premium. You could also sell another covered call for a later month. Although some people hope their stock goes down so they can keep the stock and collect the premium, be careful what you wish for.
For example, if XYZ drops a lot, for example, from $30 to $25 a share, although the $125 premium you receive will reduce the pain, you still lost $500 on the underlying stock.
Benefit: The premium will in all likelihood reduce, but not eliminate, stock losses.
Risk: You lose money on the underlying stock when it falls.
Advanced note: If you are worried that the underlying stock might fall in the near term but are confident in the longer term prospects for the stock, you can always initiate a collar. That is, you can buy a protective put on the covered call, allowing you to sell the stock at a set price, no matter how far the markets drop.
Scenario three: The underlying stock is near the strike price on the expiration date.
Some might say this is the most satisfactory result for a covered call. If the underlying stock is slightly below the strike price at expiration, you keep the premium and the stock. You can then sell a covered call for the following month, bringing in extra income. If, however, the stock rises above the strike price at expiration by even a penny, the option will most likely be called away.
Benefit: You may not be able to keep the stock and premium, and continue to sell calls on the same stock.
Risk: The stock falls, costing you money. Or it rises, and your option is exercised.
Advanced covered call strategies
- Some people use the covered call strategy to sell stocks they no longer want. If successful, the stock is called away at the strike price and sold. You also keep the premium for selling the covered calls. If you simply sold the stock, you are closing the position out. Alternatively, if you execute a covered call strategy, you have the opportunity to both close the position out and take in income on the stock. However, with this strategy, if the stock declines in value and the option is not exercised, you will continue to own the stock that you wanted to sell.
- If you want to avoid having the stock assigned and losing your underlying stock position, you can usually buy back the option in a closing purchase transaction, perhaps at a loss, and take back control of your stock.
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