Selling covered call options is an interesting idea that I discovered early on in my investing career as a way of augmenting dividends and increasing the amount of cash available in my account. Today I use these same ideas, methods and tactics to increase the income coming into my account and provide me with the ability to accumulate additional dividend paying securities.
Covered call writing is either the simultaneous purchase of stock and the sale of a call option, or the sale of a call option covered by underlying shares currently held by an investor. The key is that the call is written only when the call seller owns the underlying equity and therefore the call option is considered “covered”. The seller of the call option receives cash for selling the call but then immediately becomes obligated to sell the stock at the call's strike price if assigned, therefore limiting any upside potential in the stock price beyond the strike price if the underlying stock goes up in price. In other words, an investor is "paid" for agreeing to sell his holdings at the strike price. If the stock instead falls, there is a limited amount of price protection because the premium received from the call's sale reduces the seller’s base price.
A covered call option is best used when the investor would like to generate income off a long position while the market is moving sideways. An investor who buys or owns stock and writes call options in the equivalent amount can earn premium income without taking on additional risk. The premium received adds to the investor's bottom line regardless of outcome.
If assignment is not received because the stock price hasn’t attained the strike price, the call option will expire worthless. The seller’s resultant upside profit potential is any gain in share value that occurs prior to the expiration date plus the premium received from selling the call option contract. The downside loss potential, however, is substantial and comes entirely from owning the underlying shares. It is limited only by the stock declining to zero. The break-even point for the seller is the underlying stock price’s original purchase price minus the premium received.
This strategy is one of the most basic and widely used option strategies. It combines the flexibility of listed equity options with the benefits of stock ownership. Although this strategy may not be suitable for everyone, it can provide a stock-owning investor limited downside stock price protection in return for limited participation on the upside. More importantly the covered call sale generates income that can supplement any dividend income paid to eligible underlying stockholders.
Who Should Consider Writing Covered Calls?
- Any investor who wishes to generate income in addition to receiving any dividends from shares of underlying stock should consider writing covered calls.
- Any investor who is neutral to moderately bullish on a certain stock should consider writing covered calls on the positions they hold.
- Any investor willing to limit the upside profit potential on a specific stock in exchange for reducing the base cost of the shares owned.
How I Use Covered Calls
If I hold 100 shares of stock that has a corresponding set of options and the I have either a neutral or slightly bullish opinion on its price over a given period of time, I will sell a covered call option. I usually select an out-of-the-money call option that can be sold for a premium that provides at least some downside stock price protection. I also select a call option that fits my tolerance for risk and the time frame of my opinion. If I’m extremely bullish on the underlying stock, I may instead choose to leave the stock uncovered until it stabilizes at a higher price.
The Advantages and Risks of Selling Covered Calls
Selling covered call options offers the advantage of offsetting any downside risk and adding to the upside return, but it also means I trade current cash for any upside gains. There is also the advantage that the passage of time has a positive impact on this strategy, all other things being equal. It tends to reduce the time value (and therefore overall price) of the short call, which would make it less expensive to close out if desired. As expiration approaches, an option tends to converge on its intrinsic value, which for out-of-money calls is zero.
The risk is that the call option sell has to hold onto the shares as long as the option contract is in force. Therefore, if I want to sell my shares before option expiration, I’m required to buy back the option which may cost some or all of my calculated profits.