Covered Call Strategy for Income | The Full Guide
If you want to learn about the covered call strategy for income, this article will cover everything you need to know.
Key Takeaways
A covered call strategy is an options trading strategy that involves buying shares of a stock and then selling call options on that stock to generate income.
The strategy can be attractive to investors who want to generate income from their stock holdings and who are willing to potentially sell the shares of the stock at a higher price.
What are Call Options?
Call options are contracts that allow you to control 100 shares of stock.
Buying a call allows you to buy 100 shares of a stock at a specific strike price in exchange for a premium.
Selling a call obligates you to sell 100 shares of stock at the strike price in exchange for receiving a premium.
Covered Call Strategy for Income
The covered call strategy for income involves owning 100 shares of a stock and selling a call against them.
When you own 100 shares of stock and sell a call, you are promising to sell them at the strike price in exchange for receiving a cash premium.
When to Sell a Covered Call
Both traders and investors can benefit from a covered call strategy for income.
The best time to sell a covered call is when you own a stock and are already in profit.
For long-term investors who want to scale out of their investments, covered calls are an excellent alternative to selling shares on the open market.
Additionally, if you are a short-term trader, you can buy shares and sell a covered call at a price you are comfortable selling to collect additional income and hedge your downside risk.
Covered Call Advantages
Covered calls have various advantages, including providing downside risk and collecting income when stocks go flat.
Make money when stocks don’t move
If you sell OTM (out of the money) calls, and the stock doesn’t move, the call will lose value and provide you with additional income, similar to a dividend.
Reduce downside risk
If stocks start moving down, the call will lose value and reduce your downside risk by providing you additional income to buy more shares.
Covered Call Disadvantages
Covered calls are a great strategy, but they come with disadvantages, such as capping your upside profit potential and potentially forcing you to sell your shares at a less-than-favorable price.
Limited upside potential
If you sell a covered call and the stock moves up rapidly, the call will increase and show unrealized losses in your account, reducing your profitability on the shares.
Get called away at a bad price
If the share price goes above the strike price of your covered call, you may be forced to sell them at a price lower than what the stock is currently trading.
What Happens When a Covered Call Expires ITM?
If you have a covered call that expires ITM, it will automatically call the 100 shares out of your account and let you keep the premium.
You don’t have to do anything other than wait for the shares to disappear.
What is a Covered Call Example
Let's look at a basic example to help you understand the covered call strategy for income.
Let’s say stock ABC is trading at $100 per share
You own 100 shares at $90 per share as an investment, and you wouldn’t mind selling it at $110.
You sell -1 $110 strike call option and collect a $100 premium
In this trade, you are promising to sell your shares at $110 and collect $100 in income. Since you collected the $100 of premium, you will technically sell the shares at $111.
The four scenarios that can happen:
1- The stock stays flat, and you keep the $100 income.
2- The stock moves down, and you keep the $100 income.
3- The stock moves up significantly above $110 per share, and you are forced to sell your shares at $110 and keep the $100 income.
4- The stock drops significantly, you keep the income, but you can’t sell any calls at or above your basis for a reasonable premium.
How to Roll a Covered Call
Rolling a covered call is when you close out your current covered call and simultaneously open a new one with a different strike price and/or expiration.
The way to roll your covered call differs between the broker you use.
However, all you must do is close your current position with a buy-to-close order and sell-to-open a new one.
What is the Best Expiration for a Covered Call?
There are advantages and disadvantages to selling weekly vs. monthly covered calls.
Selling Weekly Covered Calls
Writing weekly covered calls has the most theta decay (time decay) since they expire soon. However, you will pay more commissions since you sell more contracts than you would with monthly expirations.
Additionally, you collect less premium per covered call as the shorter expirations have already decayed significantly.
Selling Monthly Covered Calls
Writing monthly covered calls allows you to collect more premium per contract while selling calls with a strike price further OTM.
You will pay less commissions selling monthly covered calls, but you will get fewer opportunities to trade since you don’t have to place trades each week.
FAQ
Are covered calls a good income strategy?
Covered calls are a common options strategy used to generate income from stocks you own or buy. By selling call options on your underlying stock, you collect a premium that lowers your cost basis and provides some downside protection. However, covered calls also limit your upside potential and expose you to the risk of losing your stock if the option is exercised.
Can you make passive income with covered calls?
Covered calls are not truly passive income, as they require active management and monitoring of the underlying stock and the option position. You may need to adjust your strike price, expiration date, or quantity of options depending on the market conditions and your investment objectives. You also need to be prepared to sell your stock or buy back your option if the option is in the money at expiration.
When should I take profit on covered calls?
There is no definitive answer to when you should take profit on covered calls, as it depends on your risk tolerance, time horizon, and market outlook. Some general guidelines are:
If the option is deep in the money and you want to keep your stock, you may consider buying back the option before expiration to avoid assignment.
If the option is out of the money and you want to keep your stock, you may consider rolling the option to a later expiration date or a higher strike price to collect more premium and extend your income stream.
If the option is near the money and you are indifferent about keeping or selling your stock, you may consider letting the option expire and letting the market decide whether you keep or sell your stock.
Is it possible to live off covered calls?
It is possible to live off covered calls, but it is not easy or risk-free. You need to have a large enough portfolio of stocks that can generate consistent and sufficient income from selling call options. You also need to have a diversified and balanced portfolio that can withstand market fluctuations and avoid concentration risk. You also need to have a disciplined and flexible strategy that can adapt to changing market conditions and manage your cash flow.
What is the downside of covered call strategy?
The downside of covered call strategy is that it limits your upside potential and exposes you to the risk of losing your stock if the option is exercised. You also incur transaction costs and commissions from selling and buying options. You also forfeit some of the benefits of owning stocks, such as dividends and voting rights, if the option is exercised.
How far out of the money should I sell covered calls?
The optimal strike price for selling covered calls depends on your risk-reward trade-off, market outlook, and time horizon. Generally speaking, the further out of the money you sell covered calls, the lower the premium you receive, but the higher the probability of keeping your stock. The closer to the money you sell covered calls, the higher the premium you receive, but the lower the probability of keeping your stock.
Should I sell covered calls before earnings?
Selling covered calls before earnings can be a risky strategy, as earnings announcements can cause significant volatility and price movements in stocks. If you sell covered calls before earnings, you may miss out on a large upside potential if the stock surges after a positive earnings report. You may also lose more than the premium received if the stock plunges after a negative earnings report.
Can you sell covered calls every week?
You can sell covered calls every week, but it may not be advisable or profitable. They have higher gamma risk, which means they are more sensitive to changes in the underlying stock price. Selling weekly options may also increase your transaction costs and commissions due to more frequent trading.
Are covered calls good during recession?
Covered calls can be a good strategy during recession, as they can provide some income and downside protection in a bearish market. However, they are not a foolproof strategy, as they can still result in losses if the underlying stock drops significantly below your cost basis. They can also limit your recovery potential if the market rebounds sharply after a recession.
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