If you’re looking for a way to make some extra money in your spare time, then you should consider learning about covered calls. Writing covered calls is one of the simplest and most popular options strategies that investors use to generate income from the stock market. In this article, we will discuss what covered calls are, how they work, and how you can make money using this strategy.
We also discuss:
- What is a Covered Call?
- How Does a Covered Call Work?
- When Should You Write a Covered Call?
- What Are the Risks of Writing Covered Calls?
- How Much Money Can I Make with Covered Calls?
- What Stocks are Good for Covered Calls?
- How Do You Manage Covered Calls?
- When Should I Sell My Covered Call Options?
- Conclusion
What is a Covered Call?
A covered call is an options strategy that involves selling a call option on a stock that you already own. The call option gives the buyer the right to purchase your stock at a set price (strike price) on or before a certain date (expiration date). By selling the call option, you are agreeing to sell your stock at the strike price if the option is exercised.
How Does a Covered Call Work?
Assuming you own 100 shares of XYZ stock, you could sell one covered call option against it. Since 1 option contract is for 100 shares, then it’s considered “covered.” Selling the option obligates you to sell your shares at the strike price if the option is exercised, but it also entitles you to keep the premium if the option expires worthless.
What is a Covered Call Example?
Let’s show how to sell a covered call on the Tastyworks trade platform.
Let’s take a look at Disney. We think it is a good stock long term and we want to own it. So we buy 100 shares of the stock at the current price. Then at the same time, we sell a call option against the 100 shares. We will pick the $115 strike since it is just out of the money and we can collect about ~$200 in premium.
By doing this, we cap out max profit at the $115 Call strike price. But that is okay, in return for doing that we are collecting the $200. So we still have a max profit of $1100 if the stock moves up to the $115 price.
If the stock price stays anywhere below the $115, then we keep the $200 collected.
When Should You Write a Covered Call?
You should write a covered call when you are bullish on a stock and want to generate income from your position.
What Are the Risks of Writing Covered Calls?
The biggest risk of writing covered calls is the same risk of owning stock: the stock price could go down. When the stock price goes down you lose money. However, you lose less than owning stock because you will keep the premium collected from the call option if it expires worthless.
Another risk is that the stock price could rise above the strike price and you would be forced to sell your shares at a lower price than what they are currently worth if the stock continued to climb. However, this is a first-world problem since the stock increased in price and you still made money!
How Much Money Can I Make with Covered Calls?
The amount of money you can make with covered calls depends on the stock price movement and the premium collected. If the stock price stays relatively static, you will make money from the premium collected. If the stock price goes up, you will make money from both the appreciation in stock value as well as the premium collected. However, if the stock price goes down, you will lose money.
The average stock market return for the S&P 500 is about 10% since its modern structure in 1957. Using the covered call strategy to add income and
There is no average return for selling covered calls. The average return for the S&P 500 is around 10% since its modern structure in 1957. The key is only to write covered calls on stocks that you believe will go up in price. I like to sell the ~30 delta call ~30–59 DTE days to expiration and collect 3–4% of the value of the stock every month. For instance right now in CHWY trading at $38.81 you can sell the 45 Call and collect 2.08 in premium. Let’s say you keep half the premium before rolling to the following month. That equates to ~2% collected per month x 12 months = 24% per year on average.
This is much better than the 10% average return of the S&P. Again you sell covered calls in stocks you think will move up in price and that you don’t mind owning.
What Stocks are Good for Covered Calls?
The best stocks for covered calls are typically large, stable companies with a history of paying dividends. These stocks tend to have less price volatility than other stocks, so there is less risk of the stock price moving sharply against you.
On the other hand, good lower-priced stocks that are undervalued and you believe will go up are great too! Since you buy 100 shares of stock with 1 covered call, the lower-priced stocks keep the buying power requirement manageable.
Most important is just picking a stock that you want to hold for the long term and think is going to increase in price.
How Do You Manage Covered Calls?
If you are bullish on the stock and believe it will continue to rise, then you can roll your covered call by buying back the option and selling a new one with a higher strike price. This allows you to keep collecting premiums as the stock price rises. If you are inside of 21 DTE Days to expiration then you can look to sell the call option in the following month.
If you have turned bearish on the stock and believe it will fall, then you can close out your position by buying back the call option. This will limit your losses if the stock price falls.
When Should I Close My Covered Call Options?
You should close your covered call options when the stock price reaches your target strike price or if you no longer believe the stock will continue to rise. Once your strike price has been reached you will be near max profit.
If you still believe in the stock and want to hold it long-term, you can buy back your call and move it out higher in the next month to collect additional premium.
Conclusion
Covered calls are a simple and popular options strategy that can help you generate income from your stock portfolio. By selling call options on stocks that you own, you agree to sell your shares at a set price if the option is exercised. However, you also collect the premium from the option if it expires worthless. Covered calls are best used on large, stable companies with a history of paying dividends and/or lower-priced undervalued companies.
Do you use covered calls? What stocks do you like to write covered calls on? Let us know in the comments below!