When I first discovered covered calls, I thought they were the greatest investment tool ever created. That was until I got burned by doing them the wrong way. I still use covered calls in my trading but with better rules and only in the most optimal situations.
What Is a Covered Call?
There are two parts to the covered call strategy. One is stock and the other is a short call. This option trade is used to increase the yield on the stock by selling an out of the money call on stock that you already own.
A Covered Call Trading Example
Let’s say you own 100 shares of IBM. The current price is $100. Since IBM is such a large company with millions of shares outstanding the price of the stock does not move around much. Let’s also assume that you think the price of the stock is going to stay around $100 for the next 30 days. If the price just sits there, you are not going to make any money. But you can if you write a covered call.
You decide to sell a 110 strike call option that will expire in 30 days. By writing this call, you get paid $2.00 per share or $200 total. This means that if IBM is below $110 on expiration day, the option will expire worthless and you get to keep the whole $200. You keep the stock too.
If IBM is above $110 at expiration, you will have to sell your 100 shares for $110 a share. But you get to keep the $2.00 per share you got paid for the option. So actually you get to sell your stock at $112.
In my opinion the best case is if IBM is at $109.90 at expiration, the call option expires worthless, the stock is up $9.90, you got $2 for the call, and you still own the stock giving you the ability to sell another call the next month at a higher strike for more money.
Technically you make the highest percentage return when the stock is sold for you by the broker at $110 (this is called having the stock called away), but I would rather keep the stock and sell another call the next month.
If you own stock that you are going to keep for years and not sell under any circumstances, selling covered calls against it is a great strategy. If you are looking to write covered calls as an income strategy, it is not the best option you have. There are other option selling strategies that are safer and can make a much higher return for the same amount of capital. These strategies are covered on other pages of this website.
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The Profit Potential of Covered Call Writing
The more volatile the stock the more expensive the calls are and so your percentage return can be great. Apple is a much more volatile stock than IBM so even if their stocks were at the same price, Apple options would cost more than options in IBM.
The Dark Side of the Covered Call
At first I did not see any flaws in the covered call strategy. I would buy some stock and sell a call against it. If the stock went up, I could either let the stock get called away or I could buy back the sold call and sell another one at a higher strike price the next month out. I thought I could just sell options month after month. If the stock went down, no problem. I would keep selling calls month after month until I collected enough money selling the calls to pay for the stock. That is what I wanted – I wanted free stock that was paid for by selling calls.
But there were a few things I did not consider.
A sharp decline in the stock would cause me to lose a lot of money, and perhaps cause a margin call. Even without the margin call I underestimated the amount of pain I could stand. Here’s a real life example. There was a stock that I bought several hundred shares of with the sole purpose to sell covered calls. I did not want to own the stock long term. I wanted to be out within a month.
The only problem was the stock dropped – big. It went from $17 to $12. The calls I had sold expired worthless. But they did not make up for the loss. So I decided to sell more calls. This time I sold them at a lower strike. The stock dropped more. And kept dropping until the low point at about $2. By then I had sold half my shares and kept the rest hoping and praying it would eventually recover
That is the dark side of the covered call. The trader has no protection on the downside. Selling the call actually makes it more complicated because if you just owned the stock you can just sell it. But if you have a call you then have to buy the call back, or keep the call and hope it expires. If the stock rebounds you could get hurt because now you have a naked call position but no stock to deliver.
That’s why covered call strategies are best used on safe, solid companies that have been around and will be around.
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Covered Calls Without Stock
One big problem with the covered call strategy is the need for a lot of capital. You have to own the stock. That ties up a lot of money as well as putting it at risk.
An alternative is to use a long call instead of stock. To do this you would buy a deep in the money call option with several months to expiration. And then sell calls against it closer to expiration. This is called a synthetic covered call.
Since the long call costs less money than the stock, not only will you have less money in the trade, but your potential return on investment is much higher as well.
Covered Call Summary
Covered Calls are a good option trading income strategy. They work most of the time. And since only one option is involved they are a good introduction to option selling. But beware the downside. Covered Calls are to be used in sideways or up markets only. There are ways to protect yourself from loss, but I find that the low return from covered calls compared to other strategies make them less attractive to full time traders.
I myself am always looking for the safest trade, which can make the most money, without me having to do much work. I started with covered calls and then upgraded to other strategies. I still do them on occasion on stocks I own in my retirement accounts. But I do not think they should be the only strategy in a trader’s tool belt.