Selling Covered Calls: An Options Trading Strategy
Selling covered calls is an options trading strategy that helps you earn passive income using call options. This options strategy works by selling call options against shares of a stock that you buy beforehand or already own.
This strategy is called “covered” because you already own the stock at the outset – you don’t need to purchase the shares on the open market at the expiration date at a price you may not like.
In addition to helping you earn passive income, this strategy can also help protect you against downside risk. Therefore, it can serve several purposes at once.
In this article, we will look closely at this options strategy and how it works. By the end, you should have a solid understanding of how to trade by selling covered calls.
What Is Selling Covered Calls?
Most ordinary investors buy shares of a company and then have a couple of paths to make money: they can either hold the shares and hope for capital gains or hold the shares and collect dividends.
But there are plenty of other ways to make money in the stock market, and some of them can boost your passive income. Selling covered calls is one of those strategies.
By using call options, you can exceed the return you would earn from a traditional stock sale. But what exactly does the strategy entail?
To employ this strategy, you start with a stock that you already own or you purchase when opening the trade. Then you sell a call option, which gives the holder the right to sell the stock at a certain price (the strike price) within a specified time period (the time to expiration). When you sell the option to the buyer, you earn income on the sale.
Ideally, the underlying stock stays out of the money until the call option expires. Out of the money means the call’s strike price is above the market price. And if that’s the case, it’s almost never exercised and you get to keep the full income you received from the trade.
However, if the option is in the money and is exercised, you already own the shares of stock that you are now required to sell to the option holder. As a result, you don’t need to purchase more shares on the open market to complete the transaction.
How Does Selling Covered Calls Work?
So how does selling covered calls work? Let’s look at the following steps.
1. Buy Shares
You purchase 1,000 shares of XYZ Corp. on the open market for $20 per share. That means you spent a total of 1,000 x $20 = $20,000.
2. Pick Your Price Target
The next step is to pick the price target you want for the trade. In our example, let’s say you choose a price target of $24 for a 20% return on the trade.
3. Select Your Options
Third, you look at the company’s options chain – the listing of all the company’s available options – and select a call option strike price that is closest to your target price. Let’s say the closest option is for a strike price of $25. This is $1 above your price target. That means if the shares are called, you receive $25 for each share.
4. Find the Cost of the Option
In this example, we find that the $25 strike 12-month call option on 100 shares of XYZ Corp. has a bid price (buy price) of $200 and an ask price (sell price) of $225. When you sell the call option, you receive the bid price of $200.
5. Sell Your Options
In our example of selling covered calls, you own 1,000 shares of XYZ stock. Therefore, you decide to sell 10 options contracts – each contract gives the call holder the right to buy 100 shares each for a total of 1,000 shares.
You sell the 10 options for $200 per contract and generate $2,000 in cash. No matter what happens next in this covered call strategy, you get to keep this income.
6. Close Out the Trade
In this example, XYZ stock never reaches the strike price, so the stock is never called and the option simply expires. The stock is now trading at $23, so you sell your 1,000 shares on the open exchange for $23,000.
In the end, you made $23,000 – $20,000 + $2,000 = $5,000 by selling covered calls and some stock price appreciation. Not bad.
Had you only purchased the stock and sold it without the options play, you would have only earned $3,000 on the sale.
The Benefits and Risks of Selling Covered Calls
So you’ve seen how selling covered calls can earn you income from the option premium while you also cash in on the appreciation of the stock price. This helps add to your return on the sale of the stock.
Another benefit of this strategy is that it limits the amount of downside risk that you have. Because you already own the shares under contract, you don’t have to purchase them on the open market when the option is exercised. This is helpful when the price of the stock has risen way above the strike price.
On the other hand, there are some drawbacks to this strategy as well. It does limit the amount of upside you have on the trade because if the stock rises well above the strike price, you need to sell it for less than it’s currently worth on the open market, capping your gains.
Another disadvantage of selling covered calls is that if you want to sell the underlying stock before the options expire, you might need to buy back the options contract. This can increase your transaction costs, limit your gains and increase your total losses.
Selling covered calls can be a great way to earn additional passive income or limit some of your risk on an options play. Of course, like any trading strategy it has advantages and drawbacks.
If you’re interested in learning much more about how to trade options, make sure to sign up for the free Trade of the Day e-letter in the signup box.
So now you have a better understanding of how selling covered calls works. If you’re interested in learning about even more options strategies, be sure to keep an eye out for the next article in this series on options trading, “Selling Naked Puts.”
About Brian M. Reiser
Brian M. Reiser has a Bachelor of Science degree in Management with a concentration in finance from the School of Management at Binghamton University.
He also holds a B.A. in philosophy from Columbia University and an M.A. in philosophy from the University of South Florida.
His primary interests at Investment U include personal finance, debt, tech stocks and more.