Introduction
Covered calls are a popular options trading strategy among stock market investors seeking a steady income stream. This comprehensive guide will demystify covered calls, explaining their mechanics, benefits, and risks. By the end, you’ll understand why investors love this strategy and how to implement it yourself.
What is a Covered Call?
A covered call involves selling call options on a stock you already own. A call option gives the buyer the right, but not the obligation, to buy your shares at a predetermined price (strike price) within a specified timeframe (expiration date). By selling a call option, you receive an upfront payment called a premium.
The Good and the Bad of Covered Calls
The Good: Guaranteed Income
The most significant advantage of covered calls is the potential to earn immediate income by selling the option. You can generate weekly, monthly, or annual income depending on the chosen expiration date.
The Bad: Limited Upside Potential
However, this income comes at a cost. When you sell a covered call, you limit your potential profits if the stock price rises significantly. If the stock price exceeds the strike price, the option buyer will likely exercise their right to buy your shares, limiting your gains.
Covered Call Scenarios: A Real-World Example
Let’s illustrate with Intel (INTC) as an example. Assume Intel trades at $32 per share. You sell a two-month call option with a strike price of $34 for $1.50 per share. Here are the possible outcomes:
Scenario 1: Stock Price Goes Down
Intel falls to $30. The option buyer won’t exercise, and you keep the $1.50 premium per share. Despite a $2 loss on the stock, you only lose $0.50 per share overall.
Scenario 2: Stock Price Remains Flat
Intel remains at $32. You keep the $1.50 premium per share, resulting in a 4.6% gain in two months (28% annualized).
Scenario 3: Stock Price Rises Slightly
Intel rises to $33. You keep the premium and gain $1 from the stock price increase, totaling a $2.50 profit (7.8% gain in two months, 46.8% annualized).
Scenario 4: Stock Price Soars
Intel skyrockets to $40. The option buyer exercises their right to buy your shares at $34. While you miss out on potential profits above $34, you still gain $2 from the stock and $1.50 from the premium, totaling $3.50 (11% gain in two months, 66% annualized).
Key Variables in Covered Calls
Strike Price
Choosing the right strike price is crucial. A higher strike price limits potential income from the premium but provides more room for the stock price to rise before your gains are capped. Conversely, a lower strike price generates higher premiums but limits your upside potential.
Expiration Date
Longer expiration dates generally result in higher premiums but lock you into the position for an extended period. Shorter expirations offer more flexibility but may come with lower premiums.
How to Write a Covered Call
- Buy the Stock: Purchase 100 shares of the desired stock.
- Sell the Call Option: Select “Sell to Open” in your brokerage account, choose the expiration date and strike price, and confirm the order.
Note: Some brokerage accounts allow simultaneous purchase of the stock and sale of the call option.
After Writing a Covered Call
- Premium Received Immediately: The premium is credited to your account upon selling the option.
- Automatic Exercise or Expiration: If the stock price exceeds the strike price, your shares will be automatically sold at expiration. If the price remains below, the option expires worthless, and you keep the premium.
Tips for Successful Covered Call Writing
- Choose Quality Stocks: Don’t write covered calls on fundamentally weak stocks; prioritize those with growth potential.
- Shop for Premiums: Compare premiums across different strike prices and expiration dates to find the best deals.
- Understand the Risk-Reward: Be aware of the limited upside potential and only write covered calls if the premium justifies the risk.
Conclusion
Covered calls can be a valuable tool for generating income from your stock holdings. However, it’s essential to understand the mechanics, benefits, and risks involved before implementing this strategy. By carefully selecting stocks, strike prices, and expiration dates, and by being mindful of the potential trade-offs, you can effectively utilize covered calls to enhance your investment returns.