Selling covered calls is a staple strategy for investors who are looking to generate income from long stocks. But there are some basics about this strategy that you must keep in mind, especially when it comes to picking the strike price of a call to sell.
As a refresher, a covered call is an option strategy where one call contract is typically sold for every 100 shares of stock owned. The premium collected from the sale goes into the call seller’s account, but the stock owner also faces the possibility of being obliged to sell her stock at the strike price she chose.
Dynamics of a Covered Call
Here’s how it can work. Assume a stock is priced at $60 and you sell a 30-day, 65-strike call for $2. The stock can move up, down, or not at all, so you’d think there’d be three potential outcomes. In reality, if you hold the option until expiration, there are only two: either the stock will be at or above the strike price of $65, or else below it.
If the stock makes it to $65 or higher by expiration, and again, assuming you hold the position all the way to expiration, then you’ll likely receive an assignment notice forcing you to sell the stock at $65. But since you brought in $2 (which is really $200 per option, since options control 100 shares), it’s really more like you sold your shares at about $67. No matter how far (or how little) beyond $65 the stock has gone, your profit/loss is figured as if you simply sold your stock at $67, minus transaction and assessment costs.
With the stock below $65, it’s likely that you won’t be assigned. Since you’re not selling the stock at $65, calculate your P/L based on the purchase price of the stock, minus the credit from the call option sale. So let’s assume you bought the stock at $60. With the call premium figured in, from a profit/loss perspective, it’s as if you paid $58. If you collect another $2 in the next expiration, figure your P/L as if you bought the stock at $56.
Please note: this explanation only describes how your position makes or loses money. It doesn’t include transaction fees, and it may not apply to the tax treatment of your position.
|Where’s the stock?||Profit/loss looks like:|
|Stock at or above strike price; short call option is assigned||Stock is sold at the strike price plus the premium collected|
|Stock below strike price; short option is not assigned||Purchase price of stock less the premium collected|
Strike Price Considerations
Notice that this all hinges on whether you get assigned, so the selection of the strike price will be of some strategic importance.
If a stock’s been beaten down and you think a rally is in order, you might decide to forgo the covered call. Even though you can usually buy back the short call to close it prior to expiration, or possibly make an adjustment, if you think the stock’s ready for a big move to the upside, it might be better to wait. Conversely, if the underlying has already had a big run and you think it’s out of steam, then you might more aggressively pursue a covered call.
Once you’re ready to pull the trigger, what strike should you choose? There’s no right answer to this, but here are some ideas to consider.
- Select a strike where you’re comfortable selling the stock. This is about as old-school as you can get.
- Choose a strike price where there’s resistance on the chart. If the stock hits the resistance and holds steady until expiration, you might hit your full profit potential for that expiration period.
- Pick a strike based on its probability of being in the money at expiration by looking at the option’s delta. For example, a call with a 0.25 delta is read by some traders to imply there’s a 25% chance of its being above the strike, and a 75% chance of its being below the strike, at expiration. It’s not exact, of course, but some consider it a rough estimate.
Covered calls, like all trades, are a study in risk versus reward. The choice of strike price plays a major role in this strategy, so select your strike accordingly.