Covered Calls Explained

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Covered Calls Explained

Covered Call investing is the most conservative of the five option investing techniques, which are: buy calls, sell calls (uncovered/naked), sell calls (covered), buy puts, and sell puts.

Covered Call investing isn’t much different than simply buying and selling stocks, which most people are already doing and are already familiar with. The difference is that, when you sell your stock which you already own, you agree to sell your stock at a certain agreed upon price known as the Strike Price. The right for someone else to hold this agreement, to buy your shares of stock at a certain price, is what’s known as an “Option”. This Option generates an “Option Price” or Option Premium, which is the key and the strength of Covered Call investing.

The Option buyer pays the Covered Call writer a Premium for the right, not the obligation, to buy the shares or Exercise the Option on or before the expiration date (the third Friday of each month).

The Magic of the Premium

The Premium the Covered Call writer collects is what makes Covered Call investing very profitable over time. For instance, if you can write Covered Calls monthly and generate an average 10% monthly profit from the combination of the premium plus any additional profit you receive from being called out, you’ll make a 120% yearly return on your investment (213% compounded)! This is much higher than any mutual fund returns. Mathematically, a $3,000 initial investment can balloon to $1,000,000 in just over 5 years if you average 10% monthly returns and don’t add any more to your original $3,000 principal investment (other than reinvesting the 10% monthly profits).

But how do you find the stock that you can buy that currently has premiums of 10% or more to write Covered Calls on that stock? What makes a good Covered Call?

We’ll answer the second question first. A good Covered Call is most often a call with a high premium (a premium that is 10% of the value of the stock or better when not on margin and not “In-the-Money”). High premiums are usually generated by positive volatility in the stock. If there is some sort of positive news or other excitement about the company the stock usually will go up, sending the premium up. Since you are usually only looking to hold onto the underlying stock for a short period of time you can use the premium percent as a guide to look for good Covered Call candidates.

You must still do your own detailed research of the fundamentals of the underlying stock to see if it’s a security you’d be comfortable holding if valuation of the stock or premium dropped.

Let’s Be Realistic and Informed

Why are there call options with such high premiums? We will quote from the expert to answer this question:

“More volatile underlying stocks have higher option prices. This relationship is logical, because if a stock has the ability to move a relatively large distance upward, buyers of the calls are willing to pay higher prices for the calls–and sellers demand them as well.”

McMillan in “Options As A Strategic Investment”

So again, we can’t stress enough:

You must still do your own detailed research of the fundamentals of the underlying stock to see if it’s a security you’d be comfortable holding if valuation of the stock or premium dropped.

By having your research pool include stocks that produce high call premiums you have another angle to find stocks that can possibly help you make monthly and yearly returns that are relatively conservative (compared to option buying) yet potentially more profitable than simply buying and holding stock.

Where to Find High Call Premiums

Right here at www.CoveredCalls.com! This is what we specialize in. Under our DATA section we post pages with the “Best Calls (Premium %-wise) for the next 30 Days, 60 Days, 90 Days”. (Remember, the premium we are talking about is the option price). These are calls, sorted by premium percent, with premium percentages that traded at 10% the value of the stock or higher that day. These premium percent values are not on margin and not “In-the-Money”. We don’t want to mask the percentages for you. (If you do choose to write on margin then your premium percentages can double!) Best of all, this is FREE information posted for our visitors!

Good luck writing Covered Calls!

Why use a covered call?

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Covered calls defined

Meet John and follow his journey into covered calls

John has some money that he would like to invest in the stock market. At this time, he is unsure of what stock to buy and hasn’t done much research yet.

There is one other important consideration for John. He would like to generate some additional income from his portfolio, as he is now semi-retired.

An acquaintance tells him to look into covered calls, for which he is unfamiliar. He decides to learn more.

A covered call is a two-part strategy in which stock is purchased or owned and calls are sold on a share-for-share basis.

The term “buy write” describes the action of buying stock and selling calls at the same time. The term “overwrite” describes the action of selling calls against stock that was purchased previously.

An example of a buy write is when an investor buys 500 shares of stock and simultaneously sells 5 call options.

An example of an “overwrite” is when an investor has owned 500 shares for some time and now decides to sell 5 calls against those shares.

Whether the shares are purchased before the calls are sold or purchased at the same time, the resulting position is described as a “covered call position.”

Potential benefits of a covered call

Covered calls offer investors three potential benefits.

    The premium received from selling a covered call can be kept as income.

Many investors use covered calls for this reason and have a program of selling covered calls on a regular basis – sometimes monthly, sometimes quarterly – with the goal of adding several percentage points of cash income to their annual returns.

Selling covered calls can help investors target a selling price for the stock that is above the current price.

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For example, a stock is purchased for $39.30 per share and a 40 Call is sold for 0.90 per share. If this covered call is assigned, which means that the stock must be sold, then a total of $40.90 is received, not including commissions. Even if the stock price only rises to $40.50, assignment means that a total of $40.90 is received. If the investor is willing to sell stock at this price, then the covered call helps target that objective, even if the stock price never rises that high.

Another reason some investors sell covered calls is to get a limited amount of downside protection.

In the example above, the premium received of $0.90 per share reduces the break-even point of owning this stock and, therefore, reduces risk. Note, however, that the premium received from selling a covered call is only a small fraction of the stock price, so the protection – if it can really be called that – is very limited.

Risks of a covered call

There are two risks to the covered call strategy.

    The real risk of losing money if the stock price declines below the breakeven point.

The breakeven point is the purchase price of the stock minus the option premium received. As with any strategy that involves stock ownership, there is substantial risk. Although stock prices can only fall to zero, this is still 100% of the amount invested, so it is important that covered call investors be suited to assume stock market risk.

The opportunity risk of not participating in a large stock price rise.

As long as the covered call is open, the covered call writer is obligated to sell the stock at the strike price. Although the premium provides some profit potential above the strike price, that profit potential is limited. Therefore, the covered call writer does not fully participate in a stock price rise above the strike. In the event of a substantial stock price rise, covered call writers often feel that they “missed a great opportunity.”

Subjective considerations

Covered call writing is suitable for neutral-to-bullish market conditions. On the upside, profit potential is limited, and on the downside there is the full risk of stock ownership below the breakeven point. Therefore, investors who use covered calls should answer the following three questions positively.

Are you willing to own the stock if the price declines?
  • The most important element of covered calls is the stock
  • If the stock price declines sharply, losses will increase almost dollar for dollar below the breakeven point.
  • It is therefore important to focus on “good quality” stocks that you are willing to own through the inevitable ups and downs of the market.
Are you willing to sell the stock if the price rises?
  • Since covered calls involve the obligation to sell stock at the strike price of the call, you must think about that obligation.
  • If you have a stock that you have owned for years and expect to own for years more, you really have to think hard about whether or not you want to sell covered calls on that stock.
  • Also, if you have a sizable unrealized profit in that stock, then selling it could trigger a substantial tax liability. On such a stock, it might be best to not sell covered calls.
  • Generally, covered calls are best when the investor is not emotionally tied to the underlying stock. It is generally easier to make rational decisions about selling a newly acquired stock than about a long-term holding.
Are you satisfied with the static and if-called rates of return?
  • At-the-money calls tend to offer higher static returns and lower if-called returns.
  • Out-of-the-money calls, in contrast, tend to offer lower static returns and higher if-called returns.
  • Which is right for you? There is no absolute “right” answer to this question. It is a subjective decision that each investor must make individually.

Key takeaways

A covered call, which is also known as a “buy write,” is a two-part strategy in which stock is purchased and calls are sold on a share-for-share basis.

Covered calls offer investors three potential benefits, income in neutral to bullish markets, a selling price above the current stock price in rising markets, and a small amount of downside protection.

Investors should also be (1) willing to own the underlying stock, (2) willing to sell the stock at the effective price, and (3) be satisfied with the estimated static and if-called returns. Losses occur in covered calls if the stock price declines below the breakeven point. There is also an opportunity risk if the stock price rises above the effective selling price of the covered call.

How to Write Covered Calls With Better Yields

With traditional investing, you buy stocks, hoping the price goes up, so that when you eventually sell you can make a profit. While this type of investing can make you money, it doesn’t always have a payout, and even when it does, you don’t always have a livable income from that payout. There are other ways to invest that will generate a steady income, however. One of the best ways is to write covered calls.

Covered calls are a specific income-producing investment strategy that allows more flexibility for short-term and long-term capital gains, while also hedging investments against a volatile market.

But if you’ve never written a covered call before – or if you have, but you’re looking to gain a higher yield – there may be a few things you need to know first.

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What to Know About Calls and Options

Covered calls are a type of option trading, and while the strategy does involve selecting stocks, the approach is a little different. Here is a breakdown of some of the terms you may need to know.

A stock option is a right that can be bought and sold. There is usually a buyer and a seller involved in the process.

A covered call is one type of option. The buyer purchases the right to buy a certain number of shares of stock that the seller owns at an agreed-upon price. This happens at any time before the option expires. The buyer doesn’t have to buy the stock, but he has the right to. Even if he doesn’t buy it, the seller keeps the money they were paid when they sold their option.

The option price, which can change as the stock moves in the market, is the price the option is bought or sold for. As with a stock, there are two prices: “Bid” and “Ask.” The buyer and seller agree on a strike price when the option is bought/sold.

For example, if you owned a stock currently trading around $43 per share, you could sell a call option that expires in June and has a strike price of $45. Two things can happen:

  • If your stock stays below $45 before the call expires (in June), you keep both the stock and the amount you sold the call for (which is called the premium).
  • If the stock rises above $45 before the call expires, the buyer exercises the call, buying the stock from you for $45 per share. You get the money from the sale of the stock and the premium, but you no longer own the stock.

A buyer has the right to exercise their option up until the expiration date. If that happens — meaning the stock is called away — the shares are automatically delivered to the buyer. Options typically expire on the third Friday of every month.

As a general rule when you buy a call option, you need the share price to move higher in order to make money and you also need it to happen within a relatively short timeframe. With each day that passes, options decay in value, which is bad for the buyer (but great for the seller).

This makes call options a great choice for sellers looking to make a profit off of stocks they already own.

How to Write Covered Calls

If you already own stocks, writing covered call options is a great way to boost your yield with lower risk.

To write a covered call option, you:

  • Choose a stock you already own and for which there is an options market (alternatively you can buy shares of stock you want to own)
  • Decide how many calls you want to write (sell)
  • Pick a strike price
  • Pick an expiration date
  • Find a buyer

Keep in mind that each call gives the owner the right to buy 100 shares of a stock or to sell 100 shares of a stock they already own. If you write two calls, that would be 200 shares, for instance.

Make sure you own enough shares of a stock to write a call, or consider buying more. Never buy a stock that you don’t want to own, as there is no guarantee it will be called away. If you don’t own the stock, then the call sale is “uncovered” or “Naked.” (This strategy is significantly riskier.)

Since the option will only get exercised if the stock rises, the best stocks to use (assuming you want to keep them) are stocks that you don’t think will go up right away. Stocks in sideways trends are good candidates.

If you sell calls expiring soon, there’s less risk that your stock will rise above the strike price and get called away, but there’s a trade-off. If you sell longer-dated calls, your premium will be higher.

Make sure you understand the risk with short-term and long-term expiration dates and how they affect your premium and stock ownership once or if the call is sold.

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Some Advice for Better Yields

If you want to make sure that your premiums have a higher yield, here are a few rules of thumb:

  • Write covered calls on stocks with dividends
  • Sell at a strike price above the current market price of the stock
  • Select near-term expirations and sell them consistently
  • Choose an underlying stock with an at-the-money option (the strike price is similar to the underlying stock’s price)

One warning: Avoid selling call options without owning the underlying stock. Only sell covered calls for stocks you own.

Also be wary of any taxes that need to be paid after a sale. If you sell a covered call and the option expires, the gain is considered a short-term capital gain, which is currently taxed as ordinary income.

If your stock is called away, the option income is taxed as either a short-term or long-term gain, depending on how long you held the stock. This will affect the overall income you receive from your call.

Final Thoughts

Writing covered calls can be an excellent strategy for investors who want to make a profit off of stocks they already own (or want to own) with higher yielding and lower-risk results.

For those that want to make a generous profit off of writing covered calls, it’s important to choose the right stocks. Those that are heavily traded with steady movement through the market (and that won’t rise or fall too quickly) are good choices.

If you’re interested in stock selection or wanting to learn more about covered calls, be sure to check out our free courses on covered calls and stock options. Since 2002, we’ve taught thousands of investors how to write covered calls and implement the Snider Investment Method on their portfolio.

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