Selling covered calls is a strategy that can help you potentially make money if the stock price doesn't move. Consider this options strategy for your portfolio.
The covered call is one of the most straightforward and widely used options-based strategies for investors who want to pursue an income goal as a way to potentially enhance returns. In fact, traders and investors may even consider covered calls in their IRAs. It’s a pretty basic and straightforward options strategy, but there are some things you need to know.
First, let’s nail down a definition. A covered call is a neutral to bullish strategy where a trader sells one out-of-the-money (OTM) or at-the-money (ATM) call options contract for every 100 shares of stock owned, collects the premium, and then waits to see if the call is exercised or expires. Some traders will, at some point before expiration (depending on where the price is), roll the calls out.
To create a covered call, a trader sells an OTM call against stock they own. If it expires OTM, the trader keeps the stock and maybe sells another call in a further-out expiration. The trader can keep doing this unless the stock moves above the strike price of the call. When that happens, the trader can either let the in-the-money (ITM) call be assigned and deliver the long shares, or buy the short call back before expiration, potentially taking a loss on that call, and keep the stock. Keep in mind, short options can be assigned at any time up to expiration regardless of the ITM amount.
Traditionally, the covered call strategy has been used to pursue two goals:
Generate income. We’ll look at a basic covered call example. Say a trader owns 100 shares of XYZ Corp., which is trading around $32. There are several strike prices for each expiration month (see figure 1). For now, let’s look at the calls that are OTM, that is, the strike prices are higher than the current price of the underlying stock. If the call is assigned and the stock is sold at the strike price, it might as well sell it at a higher price, right?
Some traders take the OTM approach in hopes of the lower odds of seeing the stock called away. Others get calls closer to the stock price, or ATM, to try get a larger credit for the calls.
FIGURE 1: STRIKE SELECTION. From the Analyze tab, enter the stock symbol, expand the Option Chain, and analyze the various options expirations and the out-of-the-money call options within the expirations. Source: the thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.
As long as the stock price remains below the strike price through expiration, the option will likely expire worthless. Options are subject to “time decay,” meaning they usually decrease in value in the days and weeks to come (all other factors being equal). This typically works in favor of the option seller.
A trader might consider selling a 37-strike call (one options contract typically specifies 100 shares of the underlying stock). The trader runs the “risk” of having to sell the stock for $5 more than the current price, so they should be comfortable with that prospect before entering the trade. But they’ll immediately collect $1.85 per share ($185) minus transaction costs. That’s in addition to whatever the stock may return during this time frame. If the call expires OTM, they could consider selling another call at a further out expiration date.
Keep in mind that the price for which a trader can sell an OTM call is not necessarily the same from one expiration to the next, mainly because of changes in implied volatility (vol). When vol is higher, the credit a trader takes in from selling the call could be higher as well. But when vol is lower, the credit for the call could be lower, as is the potential income from that covered call.
Please note: This explanation only describes how a position makes or loses money. It doesn’t include transaction fees, and it may not apply to the tax treatment of your position.
Offsetting a portion of a stock price’s drop. A covered call can compensate to some degree if the stock price drops, the short call expires OTM, and the short call’s profit offsets the long stock’s loss. But if the stock drops more than the call price, the covered call strategy can begin to lose money. In fact, the covered call’s maximum possible loss is the price at which the stock was purchased minus the credit(s) from short calls plus transaction costs. The bottom line? If the stock price tanks, the short call offers minimal protection.
Notice that this all hinges on whether the trader gets assigned, so they need to select the strike price strategically.
If a stock’s been beaten down and a trader thinks a rally is in order, they might decide to forgo the covered call. Even though they may be able to buy back the short call to close it before expiration (or possibly make an adjustment), if they think the stock’s ready for a big move to the upside, it might be better to wait. Conversely, if the underlying had a big run and a trader thinks it’s out of steam, then they might more aggressively pursue a covered call.
Once a trader is ready to pull the trigger, what strike should they choose? There’s no right answer to this, but here are some ideas to consider:
A trader might be giving up the potential for hitting a home run if XYZ rockets above the strike price, so covered calls may not be appropriate if one thinks the stock is going to shoot the moon. But in markets that’re moving more incrementally, this strategy could be beneficial. Keep in mind that if the stock goes up, the call option sold also increases in value. But that’s part of the risk with this options-based income strategy.
What happens when a trader holds a covered call until expiration? First, if the stock price goes above the strike price, the stock will most likely be called away, perhaps netting an overall profit if the strike price is higher than where the stock was purchased. Second, if the stock price moves up near the strike price at expiration, the trader would likely get to keep the stock and have the gain from keeping the full premium of the now-worthless option.
A covered call has some limits for equity investors and traders because the profits from the stock are capped at the strike price of the option. Another downside here is the chance of losing a stock a trader wanted to keep. Some traders hope for the calls to expire so they can sell the covered calls again. Others are concerned that if they sell calls and the stock runs up dramatically, they could miss the up move.
Covered calls, like all trades, are a study in risk versus return. With the tools available at one’s fingertips, traders could consider covered call options strategies to potentially generate income.
Content intended for educational/informational purposes only. Not investment advice, or a recommendation of any security, strategy, or account type.
Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.
A covered call strategy can limit the upside potential of the underlying stock position, as the stock would likely be called away in the event of substantial stock price increase. Additionally, any downside protection provided to the related stock position is limited to the premium received. (Short options can be assigned at any time up to expiration regardless of the in-the-money amount.)
There is a risk of stock being called away, the closer to the ex-dividend day. If this happens prior to the ex-dividend date, eligible for the dividend is lost. Income generated is at risk should the position moves against the investor, if the investor later buys the call back at a higher price. The investor can also lose the stock position if assigned.
The maximum risk of a covered call position is the cost of the stock, less the premium received for the call, plus all transaction costs.
Carrying options positions into expiration can entail additional risks; for example, an unanticipated exercise/assignment event could occur, or an anticipated event may fail to occur.
Rolling strategies can entail substantial transaction costs, including multiple commissions, which may impact any potential return. You are responsible for all orders entered in your self-directed account.
Market volatility, volume, and system availability may delay account access and trade executions.
Past performance of a security or strategy does not guarantee future results or success.
Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Options trading subject to TD Ameritrade review and approval. Please read Characteristics and Risks of Standardized Options before investing in options.
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