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Last updated on August 29th, 2022 at 06:49 am
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Covered calls are a popular investment strategy that gives you the right to sell calls against stocks you’ve recently purchased or those you already own. It potentially allows you to generate extra income on those shares you bought.
But do covered calls really work?
Covered calls work quite well when the underlying asset stays around or slightly surpasses the strike price. If the stock stays near the same price the call seller keeps the premium and has made an income while not having to sell the stock.
Even if the stock price goes up slightly past the strike price it can still be a win for the covered call seller. They will have received a premium when selling the call (that they keep no matter what) so they could still have profited more than what the stock price actually increased to.
The only time a covered call doesn’t work well is if the stock price skyrockets or plummets. In the first scenario the covered call seller will miss out on a lot of returns they would have had by just owning the stock.
If the stock price plummets the call seller will keep the premium but it won’t go very far towards covering the losses if the stock price dropped a lot.
In the rest of this article I will take a closer look at why covered calls work. I will also discuss when covered calls don’t work very well and what to do when that’s the case.
The Advantages of Covered Calls
For some, anything that has to do with options is considered highly risky. Depending on your risk appetite, knowing what you’re investing in is vital to the results you’ll be getting.
Since covered calls can be unpredictable, you should always weigh your risks. Although somewhat risky, covered calls pose a few advantages.
The advantages are as follows:
- Covered calls help you to generate extra revenue on shares you already own. The premium from the buyer can help you generate an extra 1–5% in returns per year on a particular stock.
- Covered calls allow you to set a target sell price for stocks you own. You can sell your stocks at a predetermined favorable level by setting a strike price slightly above the current stock price.
- The losses are defined. Other options strategies expose you to unlimited losses, but in covered calls, the worst-case scenario is losing the value of the specific stock if it becomes worthless.
How Covered Calls Work
Here’s an example to help you understand how covered calls work:
Mark buys 100 shares of company ABC at $100 per share at a total cost of $10,000. He believes the share price will rise in a month and sells one options contract (100 shares), with the strike price set at $110, to Tony. Tony pays a premium of $200 upfront for this option.
If the share price never goes above the $110 strike price, Tony won’t exercise the rights he holds on the option, and the options will expire. Mark will then keep the shares and also the $200 received as a premium.
The total profit or loss will include gains or losses due to the changes in the stock price (up or down) since Mark bought it for $100 per share.
For Mark (and anyone else selling covered calls), the ideal scenario is that the price rises to almost $110 at the expiration, with Tony failing to exercise his option. In that case, Mark will keep the $200 premium received and the shares, which are now worth $11,000 in value, for a total profit of $1,200.
The nightmare scenario here would be for the stock price to crash to zero. In this case, Mark will lose his initial $10,000 investment but keep the $200 premium received from Tony. The total loss here would be $9,800.
When Covered Calls Don’t Really Work
While covered calls have appealing perks, they can be disadvantageous, depending on the situation. Because of the risks that come with covered calls, you should always weigh your risks carefully.
Covered calls don’t work in two scenarios: during a sharp share price rally or during bear markets.
During a Sharp Share Price Rally
If the share price rises quickly, you stand to lose out on some massive gains when the buyer exercises the option.
Going back to the example above, if the stock price in Mark’s transaction quickly rises to $140 per share before expiry, Tony can choose to exercise the option.
In that case, he’ll still only pay Mark $11,000 for his shares—reflecting the originally agreed upon strike price. So, Mark will get $11,200 in total for his shares. It’s still a profit of $1,200, but Mark has missed out on an extra $3,000 in profit.
Mark now has to buy fewer shares with his money since the stock price has jumped 40% since he first bought it at $100 per share or find a different stock to invest in.
So, during a sharp price rally, covered calls put the investor at a disadvantage as they risk missing out on a huge jump in price.
During Bear Markets
Market direction is a key element to consider when using covered calls to generate extra revenue. If the stock price falls far below your cost, your options will expire, and you’ll still have to deal with owning a stock that has dropped in value.
For small losses, the premium you’ve received for the option might be enough to offset the loss. However, imagine a scenario where the company files for bankruptcy before you can sell the stock.
The share price will likely drop heavily, sometimes by more than 50%. In this scenario, the premium can’t offset the loss.
Although your covered call premium won’t cover all the losses it will help with some of it. So even in the event of an unforeseen scenario (like a bankruptcy) you are more protected than when you just own the shares.
What To Do When Covered Calls Don’t Work
Investors with stock holdings in 7-digit values will often use covered calls to make 0.5–1% of the value per month and live off it. However, when a bear market sets in, that source of income comes under threat.
If you’re in this situation, there are a few things you can do, including:
- Selling indexes that short the stock market during bear markets
- Buying protective puts
- Buying the pullback with extra cash
All of these options have their downsides, but they offer a way to hedge your exposure and limit the possible downside on your investment.
Used correctly, they may also bring in as much income as covered calls or more.
However, most analysts will advise you to diversify your income stream instead of relying on covered calls. Living off covered calls all the time is very unrealistic because bear markets are bound to happen.
With different income streams, you can wait out bear markets instead of panic-selling some of your stock to generate income. The stock market typically goes up more than it goes down.
How To Increase Your Covered Call Success Rates
The best way to increase your chances of success with covered calls is to choose a low-probability strike price. A good example is a strike price 10% higher than the current market price of the stock.
The premiums on such options are typically lower, but you’ll have a higher chance of collecting them on every option with very little risk of the option getting exercised by the buyer.
Covered calls work well, especially in bull markets. You can also collect premiums consistently in a sideways market, earning income when the stock price isn’t going in any direction.
However, the ups and downs of the market mean that covered calls don’t always work.
You need to choose a strike price that’s less likely to be hit, allowing you to pocket the premium and retain ownership of your stocks.