Are you looking for a way to generate consistent income from your stock holdings without selling them? You can do the trick using a “covered call” strategy where you make money on an option’s premium and still own the stock. Covered calls are a fantastic way to generate some additional income each month, which investors can use for further opportunities or to supplement their monthly income. It benefits conservative investors looking for steady cash flow while maintaining stock ownership.
Our guide will walk you through covered calls, how they work, and when they’re best to use in options trading. Along with discussing the benefits of the strategy, we’ll also outline the drawbacks and risks you may run into along the way. Timing is everything with covered calls, and their effectiveness is also based on the kind of investors who use them. We’ll cover everything in detail in this handy-covered calls guide!
What Are Covered Calls?
Covered calls are a neutral strategy typically employed by investors who hold assets for a long period but hold a short-term view of the asset. They’ll use the option to generate income using the option premium. Covered calls are considered a neutral approach because the investor only anticipates small increases or decreases in the underlying stock price.
Let’s get into the true definition of a covered call option and how investors put this technique into practice to generate some additional income:
Definition of a Covered Call
Covered calls are an investment strategy in which investors hold a long position in a stock and sell (write) call options on the same stock. Investors are selling a call option on a stock that they already own. Because the investor is “covered” (owning the stock), they are protected if the stock price increases and the call option expires in the money.
Key Concept
The call option gives the buyer the right to purchase the stock at a specific price (strike price) before the expiration date while the seller collects the premium. Investors must sell the stock if the stock price increases above the strike price. Following the stock sale, investors wait to see if the call is exercised or expires. Investors can earn limited returns for limited risk, generating income from the option premium. Regarding tax treatment, covered calls are subject to whether the option was qualified or in-the-money.
Example of a Covered Call
Let’s look at a simple example with actual numbers to show how a covered call works in practice:
You own 150 shares of a stock that trades around $35, and you’re willing to sell it if it goes up to $40 in the next couple of weeks. You call your broker and instruct him to sell this call option at a strike price of $40, but the broker tells you that you can trade the call option today for $5. Because you have 150 shares, you can get $750 today, which will be deposited straight into your account.
What you’ve done, in exchange for $750 today is agree to sell your 150 shares for $40 per share any time before the third weekend of the month. This is your option’s expiration date. The person who bought your call option will exercise it if the stock is over $40 on the expiration date. Essentially, they’ll buy your stock for $40 per share.
You get $6,000 (150 shares x $40 per share) plus the original $750 for selling the option. This is a grand total of $6,750 cash in your online account!
Let’s say the stock price doesn’t exceed $40 by the expiration date. In that case, the call option expires worthless—you keep the $750 premium you made, and you get to keep the stock even though you sold it to someone else. You can sell another call option against the same stock next month.
Why Use Covered Calls for Monthly Income?
While covered calls are generally used to generate additional income for a portfolio, opening the door for future investments, they can also be used for investors or retirees looking for extra income.
Generate Consistent Income
Covered calls let investors earn immediate income through the premiums they get when they sell call options. As we discussed in our example of how covered calls work, investors can choose to get a payout that day when selling call options. If the strike price never hits, the call option goes back to the seller, and they will still get to keep the premium they made while still retaining ownership of the stock. In a month, they can strike another deal—they get to collect a premium and the chance to sell the stock again. Investors can continue this process until a strike price is met, and then they must sell the stock off.
As you can see, investors can create a steady stream of monthly income through the premiums collected on these call options. However, stocks that reach the strike price need to be sold, and the investor makes money on the sale, too! It all depends on the investors and their personal strategy, but using covered calls for some steady monthly income isn’t a bad way to go!
Risk Management
Generating additional income using covered calls is a relatively low-risk strategy since the investor already owns the stock. Any losses that an investor might incur are minimal.
The risk on the option is capped because the writer owns the shares. Investors are “covered,” making it less volatile than other options and strategies. However, the shares can still drop and result in a significant loss even if the premium income helps to offset the loss. The main risk you face using covered calls is that you may miss out on stock appreciation in exchange for the premium. For example, a writer might benefit from stock appreciation up to the strike price if a stock goes through the roof after a call is written, but they won’t get more than the strike price in that scenario.
Trade-Offs
Using covered calls to generate additional income involves some potential trade-offs of upside gains in exchange for regular income. Knowing these potential downsides is essential before employing this strategy.
- Selling call options carries risk in the form of unlimited losses for the seller if the stock price increases.
- If the stock price exceeds the strike price, the stock may be called away.
- A covered call strategy can lag behind a buy-and-hold approach in rising markets.
- Investors give up some of their stock’s upside potential.
- Investors can sacrifice total return potential by capping the upside.
How to Set Up a Covered Call
Now that you know what a covered call is, how it works, and the upsides of using this approach, let’s get into the weeds on how you can set up your own covered call to take advantage of consistent monthly income on the premiums. Follow the steps below to get started today!
Step 1—Choose the Right Stock
First and foremost, you must own at least 100 shares of any stock to execute a covered call. You’ll want relatively stable stocks with moderately bullish price movements. Ideally, low-volatility stocks are best for covered calls because volatile stocks have large price swings that make it challenging to predict outcomes correctly. A stable, low-volatility stock lets investors collect premiums while running the risk of enormous price drops or substantial gains.
Step 2—Select the Right Expiration Date
There are a few considerations when choosing the correct expiration date on your covered call because your overall goal is to maximize consistent income each month. Choosing an expiration date within 30 days of collecting the option premium is best so you can rake in money every month. Think about time decay—short-dated options decay faster than long-dated options. Longer times might deliver the greatest immediate income potential, but they also carry a higher cost and breakeven price.
Step 3—Select the Strike Price
The strike price in covered calls is to set an amount you’d be comfortable selling the stock for. However, you also want to set an amount that keeps buyers interested, so there’s a likelihood each month that the shares won’t be called away, and you can continue to retain ownership with the goal of collecting a premium the following month.
Investors will often want to select a strike price that is slightly above the current stock price. In our example, we had the value at $35 with a strike price of $40, so the bid/ask spread was only $5. Some investors prefer a wider separation between the bid and ask, but it comes down to each investor’s personal taste toward risk and resistance.
Investors can incur significant losses if they choose the wrong strike price, especially if the amount is set far out of the money. Before selecting a call option, investors should check the dividends they’re entitled to, consider how much time is left until the option expires, and look at the option’s implied volatility to determine the right strike price.
Step 4—Write the Call
The process of selling call options may look different going from one brokerage platform to the next, but some general steps remain constant between various websites or mobile apps. Here’s a rough idea of what you can expect when you write your covered call on an investment platform:
- Select the option
- Access the option trade ticket
- Enter an open order to sell
- Choose the type of option
- Select the order number
- Choose the number of options you wish to sell
- Choose the expiration month
Step 5—Monitor the Position
Managing the position following a covered call is important because there are a few possible outcomes: the option could expire, you could buy it back, or you could roll it over.
- Letting the Option Expire: Expirations occur when the underlying price has moved sideways or down before expiration, and the stock price stays below the short call. In this scenario, you’re letting the option expire but still collecting the premium.
- Buy Back the Option: Buying a call option close to the expiration date allows investors to lock in profits on the options portion of the covered call as well as keep their shares. Buying back a covered call will release you from the obligation of selling the stock. Investors also stand to make a subsequent profit when they buy back a covered call and sell a call with a lower strike price.
- Roll Over the Option: Rolling over the option occurs when a covered call you sold is closed out and another covered call is sold to replace it. This might be the best option for investors who don’t see stock prices moving as expected or if the forecast significantly changes.
Calculating Potential Monthly Income
Now that we’ve discussed the benefits of using covered calls and how to set them up let’s calculate the potential monthly income you could enjoy when you pull them off successfully in options trading. Learn how to calculate the amount of the option premium you can get every month on a covered calls strategy and how the annualized return plays a crucial factor in this technique.
Premiums
The total dollar amount received in a covered call is the sum of the strike price plus the option premium (minus any commissions). The maximum profit is the difference between the strike and stock prices plus the premium the inventor receives from selling the call. There’s also the breakeven point to consider. We’ve outlined some simple formulas below that will let you calculate a covered call’s max profit and breakeven point.
- Formula for Total Dollar Amount Received—strike price + option premium – commissions
- Formula for Maximum Profit—strike price – stock price + option premium
- Formula for the Breakeven Point—stock price – option premium
Whether you’re interested in calculating the income generated from the premium or calculating potential profit based on the stock price, strike price, premium, and other factors, we’ve got you covered!
Annualized Return
After correctly assessing whether your potential returns are worth a covered call’s upside and downside risks, you’ll want to turn a potential covered call into an annualized figure. Annualizing the monthly premium income will give you a better understanding of this strategy’s long-term benefits.
Figuring out the annualized return is simple—take the net premium you get from a covered call and divide it by the cost of your shares. This is the best way to determine if a covered call is worth the risks over a long period of time. That’s why the annualized return is preferable; it covers an entire year.
Benefits of Using Covered Calls
If covered calls didn’t come with significant benefits, investors wouldn’t use them. Discover why using covered calls on predictable, low-volatility stocks is popular for investors who want to make some extra money on the options’ premiums while still maintaining ownership. Let’s take the benefits of covered calls and how they can help you access funds for additional investments or as cash.
Steady Income
Selling calls provides investors with a consistent stream of income each month. If the stock doesn’t hit the strike price you set, you still retain ownership but can collect on the premiums from the proposed sale. If the strike price isn’t reached, you can continue to sell the option each month and make a tidy little profit. This results in a steady income stream that’s helpful for older investors to put toward retirement or younger investors looking for extra cash for the cost of living.
Hedging Stock Holdings
Covered calls can help protect against slight declines in stock price. If the stock prices drop, the short call expires from the money, and the long stock’s loss is offset by the premiums gained on the short call. While this trick can help hedge stock holdings, investors need to be aware that a covered call strategy will begin to lose money if the stock drops more than the premium gained from selling the call option.
Flexibility
The beautiful part of covered calls is that there are methods for investors to adjust or roll options to adapt to changes in the market. “Rolling calls” is a technique where investors can extend the expiration date of a covered call or attain a higher or lower strike price. Having this kind of flexibility with covered calls lets bettors have control over hanging onto their stock while still collecting money from the options premium.
Risks and Limitations of Covered Calls
Covered calls might be an excellent way for many investors to generate extra monthly income. Still, covered calls come with their own unique risks and limitations that any investor should be aware of before diving in. You aren’t going to get rich with covered calls, but you can slowly earn profits over time using the options’ premiums!
Limited Upside
Investors capped their potential gains because most covered calls have a narrow bid/ask spread. This is why covered calls aren’t great for bullish investors looking for significant stock price increases. Covered calls are much better suited for investors who want to earn steady, predictable monthly returns on the options’ premiums. The upside is limited each month, which makes the covered call strategy one where monthly profit is severely limited.
Stock Being Called Away
Investors risk losing their stock at the strike price if it appreciates significantly. This can be avoided by executing a rolling call that extends the strike price so the investors can retain ownership of the stock. Anytime you perform a covered call on an option, there’s always the risk of someone else owning it when the strike price has been reached, so be thoughtful in the amount you set. You want to get buyers interested, so it must be set at a realistic price.
Market Volatility
The premise of covered calls is choosing stocks that aren’t subject to market volatility and remain steady, ensuring monthly premiums for investors. However, there’s always the chance of a volatile market environment wreaking havoc on stocks and covered calls where they underperform expectations. It’s not as bad going with low-volatility stocks, but you could suffer some serious losses or miss out on substantial gains if you’re doing a covered call on high-volatility stocks and it either underperforms or overperforms.
Advanced Tips for Covered Calls
We’ve discussed the basics of covered calls, but now we’ll discuss some of the advanced tips to take your strategy to the next level. Some of these concepts were alluded to earlier in the guide, but we’ll fully flesh them out here, including methods like rolling calls and using covered calls on ETFs. This portion of the guide will also highlight tax considerations in relation to covered calls.
Rolling Calls
This strategy involves closing out an existing covered call and replacing it with a new one. It’s popular to use rolling calls if the stock price rises, the stock price drops, or the investors want to extend the expiration date. Rolling a call during a stock price rise allows the investor to attain a higher strike price to avoid selling the stock. Rolling a call during a price drop enables the investor to achieve a lower strike price to deal with a major price drop of sideways trading. Rolling covered calls to new strike prices or expiration dates lets investors maximize potential income or avoid assignment.
Use of Covered Call ETFs
Covered call ETFs are helpful for investors who don’t want to manage their trades manually. They involve selling an out-of-the-money call against each 100 shares or ETF shares. If the stock price has risen enough, covered call, ETFs sell shares at the strike price of an option automatically.
However, covered call ETFs come with some risks. For example, they are subject to market risk—their value declines if the overall market declines. They also have a large tax drag on returns because ETFs generate a lot of income from covered calls. This particularly affects investors in higher tax brackets.
Tax Considerations
Income or loss on closed calls is only recognized when the call is closed when assigned, a closing purchase transaction occurs, or the call expires as worthless.
- Closed When Assigned: Take the strike price plus the premium, and this is the sale price of the stock. Gains or losses depend on the holding period. If the holding period is more than a year, gains or losses would be long-term.
- Closed Via Purchase Transaction: Net capital gains or losses are short-term for tax considerations.
- Expires as Worthless: The net cash an investor gains is considered short-term at the time of the sale, regardless of how long the position was open.
Who Should Use Covered Calls?
Covered calls might not be the best fit for every kind of investor, including those with a bullish approach, those who expect large stock price increases, or those who hold onto stocks for a long time. We’ll review the profile of the ideal investor who can use covered calls to their advantage and some prime examples of when it’s best to use a covered call in options trading.
Profile of an Ideal Investor
Covered calls are used by investors who want to hold the underlying stock for a long time but don’t expect big price increases soon. It’s a strategy used mainly through conservative, income-focused, moderately bullish investors who don’t expect significant upside. It’s best for investors who hold low-volatility stocks that aren’t subject to major swings, so investors aren’t incurring huge losses or missing out on substantial gains.
Covered calls aren’t great for bullish investors because the option caps the stock’s profit, so any gains you make aren’t too substantial. Small amounts accrue over a longer period. This method isn’t excellent for those expecting significant increases in the stock price or those who don’t want to risk losing a stock. In covered calls, there’s always the chance of the stock being called away if it hits the strike price; these stocks aren’t subject to wild market swings (which ends up being perfect for collecting monthly premiums).
Examples of When to Use
Some situations are preferable to others when using covered calls in options trading. It all comes down to each investor’s individual goals and personal strategy
- Use a covered call to generate income on the option’s premium.
- Covered calls are helpful in selling a stock you want to eliminate from your portfolio. They help establish a selling price and attract buyers.
- If trading in a tax-advantaged account, you can use covered calls to create tax liabilities (income generated from the premiums and the change that the stock is called away).
Covered calls might be helpful in market environments where things are stagnant or mildly bullish. The entire idea is choosing stocks without significant swings in value because you don’t want to suffer substantial losses or miss out on huge gains. Investors who wish to execute successfully covered calls and reliably generate monthly income on the premiums might want to choose from the following stocks:
- PepsiCo, Inc. (PEP)
- Walmart Inc. (WMT)
- ConocoPhillips (COP)
- Johnson & Johnson (JNJ)
- Verizon Communication (VZ)
- Oracle Corporation (ORCL)
- Apple Inc. (AAPL)
- Microsoft Corporation (MSFT)
These stocks are relatively stable and have moderately bullish price movements. They’re also low-volatility stocks, lacking large price swings. These stable choices make it easy to predict outcomes correctly.
Get a Steady Return Each Month Using the Covered Calls Strategy
Suppose you have steady, low-volatility positions, stocks, or options in your portfolio. In that case, you can take advantage of how even-keeled they regard market movement and do a covered call to generate a reliable monthly income on the options’ premiums. Explore your portfolio for potential covered call opportunities, or start small by experimenting with this strategy on a demo trading account.
