Last Updated: 5 months ago by BrodNeil
Have you heard about the covered calls? Do you want to learn more about this trading strategy and use it to your advantage in the stock market? Then read on.
Whether you’re a seasoned investor or just stepping into the world of options trading, understanding this strategy can be a game-changer. This guide will provide a clear and concise roadmap to comprehending covered calls. We’ll learn the fundamentals and techniques, equipping you with the knowledge to use covered calls effectively and boost your investment returns.
Let’s get started.
- What are covered calls
- How a covered call works
- Key components of covered calls strategy
- Understanding covered calls
- Pros and cons of covered calls
- Covered Calls on ETFs
- When is the best time to use covered calls?
- When to avoid a covered call
- How to implement a covered call strategy
- 1. Select an appropriate stock or ETF.
- 2. Perform fundamental and technical analysis.
- 3. Decide on your investment objective.
- 4. Choose the expiration date.
- 5. Determine the strike price.
- 6. Sell the call option.
- 7. Receive premium income.
- 8. Monitor the position.
- 9. Manage the position as needed.
- 10. Close or roll the position.
- 11. Evaluate and learn.
- Stock market courses and covered calls
- Covered calls FAQs
- 1. What happens if the call option is not exercised?
- 2. How is profit calculated in covered calls?
- 3. How is the premium determined in covered calls?
- 4. Can covered calls be rolled over?
- 5. Are covered calls suitable for every investor?
- 6. Can covered calls be used in retirement accounts?
- 7. What is the ideal timeframe for holding a covered call position?
What are covered calls
Covered calls are a sophisticated yet popular options trading strategy employed by investors to generate income while holding a long position in a particular stock. It involves two key elements: owning the underlying asset (usually shares of a stock) and simultaneously selling a call option on that same asset. This strategy is often used when an investor expects the stock’s price to remain relatively stable or only increase modestly in the short term.
How a covered call works
The mechanics of a covered call strategy are relatively straightforward. Let’s break it down step by step:
Step 1: Ownership of the underlying asset
The first requirement for executing a covered call is to own the underlying asset. You must possess shares of a specific stock in your portfolio.
Step 2: Selling a call option
In the second step, you sell (or “write”) a call option on the same stock you own. This call option comes with a predetermined strike price and an expiration date. The strike price is the price at which the buyer of the call option has the right to purchase your shares. The expiration date is the point at which the option contract either gets exercised or expires worthless.
Step 3: Receiving a premium
In exchange for selling the call option, you receive a premium or an upfront payment from the buyer. This premium provides immediate income for you, regardless of what happens with the option later on.
Step 4: Two possible outcomes
After selling the call option, two scenarios can unfold:
- Option Not Exercised- If the stock price remains below the strike price at the option’s expiration date, the call option typically expires worthless, and you keep both the premium you received and your shares.
- Option Exercised- If the stock price rises above the strike price and the buyer exercises the call option, you’ll be obligated to sell your shares at the strike price. While this may result in you missing out on potential gains if the stock continues to rise, you still retain the premium received, which can offset any losses.
Key components of covered calls strategy
As mentioned earlier, a covered call involves two key elements.
1. The call option
The call option is the financial contract that grants the buyer the right, but not the obligation, to buy a specific number of shares (usually 100 shares per contract) at the strike price before or on the option’s expiration date. When you sell a call option, you take on the option writer or seller role. You are obligated to sell your shares at the strike price if the buyer decides to exercise the option.
2. The underlying asset
This refers to the actual stock that you own in your portfolio. It’s the foundation of the covered call strategy because you cover the potential obligation to sell these shares at the strike price if the call option is exercised. Owning the underlying asset provides the “coverage” in the covered call strategy, reducing the risk compared to selling naked calls.
Covered calls allow investors to generate income while maintaining a long stock position. By understanding this strategy’s mechanics and key components, you can make informed decisions to enhance your portfolio’s performance and manage risk effectively.
Understanding covered calls
Let’s further understand covered calls as a trading strategy:
What is your maximum profit for covered calls?
The maximum profit you can attain with a covered call is capped at the premium you receive for selling the call option. This premium is your immediate income from the trade. If the stock price remains below the call option’s strike price by the option’s expiration date, the call option typically expires worthless, and you retain both the premium and your shares. Thus, your maximum profit equals the premium collected.
What is your maximum loss for covered calls?
The maximum loss in a covered call strategy primarily stems from the potential decline in the value of the underlying stock. Your loss is cushioned by the premium you received when selling the call option. If the stock’s price significantly drops, the premium may not fully offset the paper loss in the stock’s value. However, this loss is limited to the difference between the stock’s purchase price and its current market price plus the premium received.
The risk profile of covered calls
When employing this options trading strategy, the risk profile of covered calls is crucial. Covered calls typically have a relatively conservative risk profile compared to other options strategies, but they still entail certain risks.
Here’s a detailed breakdown of the risk profile of covered calls:
- Limited downside protection: One of the critical features of covered calls is their ability to provide some downside protection. By selling a call option on a stock you already own, you receive a premium that cushions against potential losses in the stock’s value. This premium reduces the overall risk compared to holding the stock without any protection. However, the protection is limited and may not fully offset significant declines in the stock’s price.
- Capped upside potential: While covered calls reduce downside risk, they also limit your potential gains. When you sell a call option, you agree to sell your shares at the strike price if the option is exercised, even if the stock’s market price is higher. This means you might miss out on additional profits if the stock experiences substantial price appreciation beyond the strike price. The extent to which your potential gains are capped depends on your chosen strike price.
- Opportunity cost: There’s an opportunity cost associated with covered calls. If the stock appreciates significantly and the call option is exercised, you’ll sell your shares at the strike price, missing out on potential further gains in the stock’s value. The premium received partially offsets this opportunity cost, but weighing the potential gains against the premium and your overall investment goals is essential.
- Stock ownership risk: Covered calls require you to own the underlying stock. Therefore, you are exposed to all the risks of owning that particular stock, including market volatility, company-specific news, and broader economic factors. If the stock experiences a severe decline, the premium received may not fully offset your losses.
- Assignment risk: There’s always a possibility that the buyer will exercise the call option you sold. If this happens, you’ll be obligated to sell your shares at the strike price, even if you didn’t intend to do so. Assignment risk is higher when the stock’s price exceeds the strike price as the option expires.
- Time decay: Time decay, or theta decay, is a risk associated with all options strategies. As time passes, the call option’s value erodes, which can work in your favor as the seller. However, it also means that if the stock’s price remains relatively stable or declines, the premium received may not fully compensate for the loss in the option’s value.
Covered calls are considered a conservative options strategy with limited downside risk compared to other strategies. They provide income through premium collection and can be helpful in income generation and risk management. However, it’s essential to carefully consider the risk profile of covered calls, including the potential for limited gains and the risks associated with owning the underlying stock. Your risk tolerance and investment objectives should guide your decision to use this strategy.
Tax advantages associated with selling covered calls
Covered calls can offer some tax advantages for investors:
- Income tax: The premiums received from selling covered calls are generally considered income and are subject to income tax. However, this income is earned when the option is sold and only realized once the option is exercised or expires. This can provide a measure of flexibility in managing your tax liabilities.
- Capital gains tax: If the stock is ultimately sold, any capital gains or losses from the stock sale are typically treated as capital gains or losses for tax purposes. The premiums received from covered call options can help offset potential capital losses, potentially reducing your overall tax liability.
- Tax efficiency: Covered calls can efficiently generate income from your portfolio while managing tax implications. By strategically choosing which call options to sell, you can align your tax strategy with your overall financial goals.
Understanding the maximum profit, maximum loss, risk profile, and tax advantages associated with selling covered calls is essential for making informed investment decisions. Covered calls offer a structured approach to income generation and risk management, but they come with trade-offs that should align with your overall financial objectives and risk tolerance.
Pros and cons of covered calls
Let’s explore the positive aspects of using covered calls in your investment strategy and consider its potential drawbacks and challenges.
Advantages of covered calls
Covered calls offer several advantages for investors, including income generation, downside protection, and risk management.
- Generating income: One of the most significant advantages of using covered calls is the ability to generate revenue. You receive a premium upfront by selling call options on stocks you already own. This premium acts as immediate income, providing a consistent cash flow, regardless of whether the option is exercised or expires worthless.
- Limiting potential losses: Covered calls offer a degree of downside protection. The premium received when selling the call option partially cushions potential losses in the stock’s value. While it may not fully offset significant declines, it reduces the net loss compared to simply holding the stock without any protection.
- Managing risk: Covered calls provide a structured approach to risk management. They can be beneficial in volatile markets or when holding stocks with uncertain near-term prospects. The income from premiums helps offset potential losses, enhancing your overall portfolio risk management.
Drawbacks of covered calls
While covered calls have their merits, they also have drawbacks, including potential missed opportunities, vulnerability to market volatility, and the obligation to sell shares under specific conditions.
- Potential missed opportunities: Selling covered calls means committing to sell your shares at a predetermined strike price if the option is exercised. This can result in missed opportunities for additional gains if the stock’s price appreciates significantly beyond the strike price. Investors must weigh the potential gains against the premium received and their overall investment goals.
- Market volatility: While covered calls provide some downside protection, they may not fully shield your portfolio during periods of extreme market volatility. If the stock experiences a rapid and substantial decline, the premium received might not be sufficient to offset the losses.
- The obligation to sell: When you sell a call option, you must sell your shares at the strike price if the buyer exercises the option. This obligation can limit your flexibility, as you may be forced to sell the stock even if you prefer to hold it. This is crucial when choosing which stocks to use in a covered call strategy.
Covered Calls on ETFs
Covered calls can be effective when applied to Exchange-Traded Funds (ETFs). ETFs are investment funds that hold a diversified portfolio of assets, such as stocks, bonds, or commodities, and are traded on stock exchanges like individual stocks. When used in conjunction with ETFs, covered calls offer unique advantages and considerations:
Exploring the use of covered calls strategy with ETFs
Covered calls on ETFs involve selling call options on an ETF while simultaneously holding a long position in that same ETF. This strategy can be particularly attractive for various reasons, including the following:
- Diversification: ETFs inherently provide diversification since they typically track a specific index or asset class. You can generate income from a diversified portfolio using covered calls with ETFs, reducing the risk associated with individual stock positions.
- Income generation: ETFs often pay dividends or interest, which can complement the income generated from selling covered call options. This dual income stream can enhance your overall returns.
- Liquidity: ETFs are highly liquid, making them suitable for options trading. You can easily buy and sell ETFs and their associated options, allowing flexibility in your trading strategies.
Benefits and considerations specific to ETFs
Employing covered calls with ETFs introduces a unique dimension to options trading. Below are the advantages and factors to consider when using this strategy with these diversified investment vehicles.
- Diversified income: ETFs offer exposure to a broad range of assets. This diversity can result in more stable income generation through covered calls than relying solely on individual stocks.
- Reduced single-stock risk: Utilizing covered calls on ETFs minimizes the risk of holding individual stocks. A significant decline in one stock within an ETF is less likely to impact your portfolio dramatically.
- Accessibility: ETFs are accessible to many investors and can be easily traded through brokerage accounts. This accessibility makes implementing covered call strategies more straightforward for many individuals.
- Limited control: When using covered calls on ETFs, you have limited control over the individual assets within the fund. You can’t select or alter the underlying assets, which may not align perfectly with your investment goals.
- Expense ratios: ETFs often have expense ratios that can affect your returns over time. While covered calls can offset some of these costs, evaluating the impact of fees on your strategy is essential.
- Tracking error: Some ETFs may not perfectly track their underlying index due to tracking errors. This can affect the performance of your covered call strategy, so it’s important to understand the ETF’s tracking history.
Covered calls on ETFs offer a compelling way to generate income, reduce single-stock risk, and benefit from diversification. However, when considering this strategy, investors should be mindful of the limited control over underlying assets, expense ratios, and potential tracking errors. ETFs can be an excellent vehicle for implementing covered calls, particularly for those seeking a balanced income generation and risk management approach in their investment portfolio.
When is the best time to use covered calls?
You can strategically employ covered calls during different market conditions to achieve specific objectives:
1. Bullish market conditions (when the market is rising)
During bullish market conditions, when you expect the prices of the underlying assets to rise steadily or moderately, covered calls can be a valuable addition to your strategy. Here’s why:
- Enhanced returns: By selling covered calls on stocks you believe will appreciate, you can improve your overall returns—the premiums you receive from selling call options act as additional income on top of any capital gains.
- Capitalizing on short-term plateaus: In bullish markets, stocks may experience short-term plateaus or minor pullbacks. Covered calls can help you capitalize on these temporary stagnations by generating income through premiums while waiting for the stock to resume its upward trend.
2. Income generation during sideways markets (when the market is range-bound)
In markets characterized by sideways or range-bound movement, where stock prices don’t show significant upward or downward trends, covered calls generate income. Here’s how:
- Steady income stream: Covered calls can provide a consistent income stream regardless of the market’s overall direction. When the stock price remains relatively stable within a range, you can repeatedly sell call options and collect premiums, boosting your income.
- Reduced risk: Sideways markets often involve lower levels of volatility. Selling covered calls can help you take advantage of this reduced-risk environment while still generating income, thus adding a level of stability to your portfolio.
3. Mitigating downside risk in a bearish market (when the market is bearish or uncertain)
In bearish market conditions or when you anticipate a potential downturn, covered calls can serve as a risk mitigation tool by providing the following:
- Partial hedge: While covered calls do not provide complete protection, they offer a partial hedge against losses. The premiums received from selling call options can offset some of the declines in the stock’s value, reducing your overall loss.
- Income generation amid uncertainty: When the market outlook is uncertain, covered calls allow you to generate income while waiting for a potential recovery. Even if the stock’s price declines, you still benefit from the collected premiums.
The best time to use covered calls depends on your market outlook and investment goals. They shine in bullish markets by enhancing returns, generating consistent income during sideways movements, and mitigating risk in bearish or uncertain market conditions. As with any investment strategy, aligning your use of covered calls with your overall portfolio strategy and risk tolerance is essential.
When to avoid a covered call
While valuable in many scenarios, covered calls may not always be the ideal choice. There are some situations when it’s best to avoid employing this strategy.
- Highly bullish markets: In extremely bullish markets where stocks are consistently and rapidly appreciating, using covered calls might not be optimal. By selling call options, you cap your potential gains, potentially missing out on significant profits.
- Low volatility markets: When market volatility is exceptionally low, the premiums offered for call options may be insufficient to justify the strategy’s risk-reward profile. Covered calls thrive in more moderate volatility environments.
- Expecting a significant stock price jump: If you anticipate a substantial and sudden increase in the stock’s price, using covered calls can limit your upside potential. In such cases, you might prefer to hold the stock without selling call options.
Recognizing Signs to Avoid Covered Calls
It’s essential to be alert to specific indicators and market conditions that suggest it might be wise to avoid using covered call strategies.
- Strong earnings expectations: If a company is about to announce earnings, especially if you anticipate positive results that could lead to a substantial stock price jump, it’s often wise to avoid covered calls. Earnings surprises can significantly impact stock prices, and you might miss out on potential gains if you’ve sold call options.
- Upcoming corporate actions: Be cautious when a company has significant corporate events, such as mergers, acquisitions, or spin-offs, on the horizon. These events can introduce uncertainty and potential stock price fluctuations that might not align with your covered call strategy.
- Limited downside protection: Avoid covered calls if your primary objective is to protect your portfolio from significant downside risk. While covered calls offer some protection, they may not be sufficient in highly bearish markets or during sharp stock declines.
Alternative Strategies for Different Market Conditions
When covered calls aren’t the best fit for your investment goals or the prevailing market environment, alternative strategies will suit various conditions and objectives.
- In highly bullish markets: Consider holding onto your stocks without selling call options in exceptionally bullish markets. This way, you can fully participate in the potential upward momentum and capitalize on any substantial price increases.
- With low volatility markets: Explore alternative income strategies, such as cash-secured puts or dividend-focused investing, when market volatility is low. These strategies can provide income while aligning with the market environment.
- When expecting a significant stock price jump: If you anticipate a substantial and sudden increase in a stock’s price, you might opt for strategies that allow you to benefit from the potential upside. These could include buying call options (going long) or utilizing techniques like straddles or strangles to capitalize on volatility.
Tailoring your approach to the specific market conditions and investment objectives is key to successful options trading.
How to implement a covered call strategy
If you are ready to invest in covered calls or are curious about the process, below is a step-by-step guide to successfully implementing the investment strategy.
1. Select an appropriate stock or ETF.
- Choose a stock or ETF you currently own or are willing to buy.
- Look for assets with stable or moderately bullish price expectations. Stocks with low to moderate volatility are often preferred.
2. Perform fundamental and technical analysis.
- Conduct thorough research on the selected asset, including its financial health, growth potential, and recent performance.
- Use technical analysis to identify support and resistance levels, helping you determine suitable strike prices for your covered call options.
3. Decide on your investment objective.
- Clarify your investment goals. Are you primarily seeking income, downside protection, or a balance between the two?
4. Choose the expiration date.
- Select the expiration date for your call option. Typically, options expire on the third Friday of the expiration month.
5. Determine the strike price.
- Choose the strike price at which you will sell your stock if the call option is exercised. This should align with your investment objective and your assessment of the asset’s potential price movement.
6. Sell the call option.
- Sell a call option on the selected stock or ETF through your brokerage account. Ensure you own at least 100 shares of the asset for each call option contract you sell, as options contracts are typically based on 100 shares.
7. Receive premium income.
- Upon selling the call option, you’ll receive a premium from the buyer, immediately credited to your account as income.
8. Monitor the position.
- Continuously monitor the performance of your covered call position. Pay attention to changes in the underlying asset’s price and overall market conditions.
9. Manage the position as needed.
- Depending on how the market and the underlying asset evolve, you may need to make adjustments. Consider rolling the option if the stock’s price approaches or exceeds the strike price. This means buying back the current option and selling a new one with a later expiration date or a higher strike price. On the other hand, consider allowing assignment to occur.
10. Close or roll the position.
- As the option expires, you can close the position by buying back the call option, effectively ending the covered call strategy.
- Alternatively, if you still want to maintain your stock position and continue generating income, you can roll the option mentioned in step 9.
11. Evaluate and learn.
- After the position is closed or rolled, take time to evaluate the effectiveness of your covered call strategy. Consider what worked well and what could be improved for future implementations.
By following these steps and staying informed about market conditions, you can successfully implement a covered call strategy as part of your investment portfolio.
Stock market courses and covered calls
If you are new to investing, you may also want to consider getting assistance from experts by enrolling in a stock market course. You will get a solid foundation in financial markets and develop the following skills:
- Understanding the basics: Education in trading begins with understanding the fundamental concepts of financial markets, including stocks, options, and risk management. It equips you with the knowledge needed to make informed decisions.
- Risk mitigation: Education helps you recognize and manage risks. This is particularly crucial when trading options, where strategies like covered calls have benefits and potential downsides.
- Strategy development: Learning about different trading strategies, including covered calls, empowers you to choose the most suitable approach based on your financial goals and market conditions.
- Continuous learning: The stock market is dynamic, with market conditions evolving over time. Ongoing education keeps you updated on new strategies, market trends, and economic events that can impact your trading decisions.
Where to learn about the stock market and covered calls
Before enrolling in a stock market course, assess your current knowledge and goals in trading. Look for reputable sources, such as established educational institutions or industry-recognized experts, to ensure the course meets your needs.
You may also check out Fokas Beyond, which has over 70 years of experience in the stock market. They educate like-minded individuals in investing in the stock market while understanding the risks and protecting 90-99% of your capital. There’s another catch – they don’t use the traditional buy-and-hold strategy. Plus, they provide one-on-one coaching, which makes them different from other stock market courses. Check out their masterclass here to learn more.
Covered calls FAQs
Apart from the essentials we discussed earlier, here are some helpful FAQs about covered calls and their answers:
1. What happens if the call option is not exercised?
If the call option is not exercised by the buyer, it expires worthless. The seller (the investor employing the covered call strategy) retains the premium received and ownership of the underlying asset (stock or ETF).
2. How is profit calculated in covered calls?
Profit in a covered call is calculated by adding the premium received from selling the call option to any capital gains or losses in the stock’s value. The maximum profit is limited to the premium, while the maximum loss is typically associated with potential stock price declines.
3. How is the premium determined in covered calls?
The premium received for selling a covered call is determined by several factors, including the stock’s price, the option’s strike price, the time remaining until expiration, and market volatility. Higher volatility and a closer strike price to the current stock price typically result in higher premiums.
4. Can covered calls be rolled over?
Yes, covered calls can be rolled over by buying back the current call option and selling a new one with a later expiration date or a different strike price. This can be done to extend income generation or adjust the strategy based on changing market conditions.
5. Are covered calls suitable for every investor?
Covered calls are not suitable for all investors. They are best suited for those seeking income generation with a moderate risk tolerance. It’s important to assess your financial goals and risk tolerance before using this strategy.
6. Can covered calls be used in retirement accounts?
Yes, covered calls can be employed in retirement accounts such as IRAs (Individual Retirement Accounts) and 401(k)s, provided that the brokerage or financial institution where the account is held allows options trading.
7. What is the ideal timeframe for holding a covered call position?
The ideal timeframe for holding a covered call position depends on your investment goals. Some investors choose short-term expirations (weeks to months) for frequent income generation, while others prefer longer-term expirations (several months to a year) for a more passive approach.
Covered calls are a versatile investment strategy offering income generation and risk management potential. Whether in bullish, sideways, or bearish markets, they provide an additional tool for investors to enhance their portfolio’s performance while managing risk. However, understanding the strategy and its risks and aligning it with your financial goals is essential to successful implementation.
We hope this comprehensive guide has been helpful to you.
Please note that the information provided above is for educational purposes only. Trading and investing in the stock market involves risk, and past performance does not indicate future results. We highly recommend conducting thorough research, seeking professional financial advice, and considering your investment goals and risk tolerance before making investment decisions.
Fokas Beyond offers a stock market course in Australia.
Please be aware that the content discussed does not constitute financial advice or recommendations. Your participation in the stock market carries risks and rewards, and it is important to make informed decisions based on your own judgment.
Always remember that investments can fluctuate in value, and it is crucial to carefully consider your own circumstances and objectives before making any financial commitments.