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A covered call is standard among investors who believe the underlying price of stocks won’t move much further over the near term. Investors holding long-term assets then write (sell) call options on the same asset to generate income.
You should sell covered calls to help make additional income from shares in your portfolio. However, you should only sell a covered call if you believe the stock price will stay relatively flat or go down slightly.
Selling covered calls allows you to get some extra income from stocks that you already hold but you do limit your upside to the strike price plus the premium you receive when selling the call.
So if you sell a covered call on a stock with a strike price of $50 for $1 you will receive $100 (since they are in lots of 100 shares). But if the stock price goes a long ways above $50 you will still have to sell those shares at the $50 strike price.
Read on to discover: when it is best to sell covered calls, the best covered call strategy, advantages and risks, and why you should consider selling covered calls.
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Why You Should Sell Covered Calls
A call option is the most profitable if stocks move up near the strike price but doesn’t go over it. The buyer pays the seller a premium to obtain the right to buy shares at a future price within a period of time, generating income from long stock positions.
The premium is the cash paid on the day the call option is purchased. Regardless of whether the buyer exercises the option or not, the seller gets to keep the premium money.
When you plan to sell your covered calls, there are a couple issues to consider: taxes and transaction costs.
- Covered calls result in tax inefficiencies. Depending on the writing option, some or all of the income will be treated as a short-term capital gain. The lost capital when the option is exercised is taxed at a capital gains rate as well.
- Covered calls entail high transaction costs. The commission, bid offers, and the market impact affect the cost as well. To help negate this negative impact you should trade using an online broker with lower fees.
Personally, I like to trade covered calls inside of my IRA with an online broker that has free stock and options trading (besides a tiny fee per options contract). This helps to virtually removed both of these negatives.
Best Time To Sell Covered Calls
Considering the best time to sell covered calls is a critical issue you have to plan. Writing calls against shares or stocks may be a crucial option strategy for your short-term gain, so finding the best time to sell covered calls is essential.
The most ideal and obvious time to sell covered calls is when the price is moving higher and you consider your stock or shares to be overvalued.
You can consider selling your covered call at a strike price that is substantially higher than fair market values, but you will get a much lower premium.
If you feel like the stock has run up a lot recently and expect a small pullback then selling a covered call near the money or even in the money is a great way to protect your investment from some of the downside risk.
Say for example I bought a stock at $50 that recently ran up to $75. If I still like the long term prospects of the stock and believe it could go higher long term but think a pullback is imminent then I could sell a covered call.
Let’s say I sell a call at the money (ATM) so the strike price is $75 and let’s say that I receive $2 to do that.
That means even if the stock pulls back to $73 I still haven’t lost any money. However if the stock keeps climbing I will miss out on additional profit if it climbs above $77.
Risks and Advantages of Selling Covered Calls
Advantages Of Covered Calls
Selling covered calls can generate an extra income from shares you hold in your portfolio. Aside from the dividends on stocks, selling covered calls is a great way to get some extra monthly income.
You may consider selling your stock when it rises a few dollars, but it may be frustrating to see your stock bouncing back to the original price. A covered call can give you some extra cash while you wait for the stock to rise.
The buyer’s premium is for you to keep even if you do not have the stock called away from you at expiration; you still hold on to the cash for the opening position.
Covered calls lower the cost of buying shares of stock as well. If you are able to sell a covered call every month against your stock position you can continually decrease your cost basis in that stock.
The risk of a covered call strategy is minimal when compared to other option trading strategies. You can minimize your risk without losing all of your capital as with buying directional calls or puts.
Risks Of Covered Calls
The main risk of covered calls is missing out on stock appreciation in exchange for the premium. If a stock appreciates after a call was written, the investor only benefits from the stock appreciation up to the strike price.
If the stock passes the strike price by a large amount then in that case, it would have been more favorable to hold the stock than to sell calls.
Selling a call option is considered low risk, which sometimes isn’t necessarily true because shares can significantly drop, causing huge losses. Although, premiums help to cover the loss but only slightly.
Selling covered calls is best used as a monitoring strategy to avoid potential pullbacks or to be used as a way to generate monthly income.
Selling calls can make investing more complicated and they involve more transactions and commissions as well.
Also, you must continue to own the stock until the expiration date (or buy the call back) to allow the stock to remain covered. However, it can force you to own stock longer than desired, which is terrible if you are planning to sell some of your investment.
Best Covered Calls Examples
Let’s assume John buys 100 shares at ABC company for a sum of $5,000 ($50 per share). He expects the share price to rise, but only slightly in the short term. So, he sells one option contract at a strike price of $55 to Mike who pays a premium of $1 for this call option.
Suppose the price doesn’t rise above $55 prior to the call’s expiration. It is unlikely Mike would exercise the option; which means it would expire worthless. John gets to keep his shares and pocket the $100 Mike paid him. His total profit will be $100, excluding any changes in the price of the ABC stock from the $50 per share purchase price.
It is in John’s best interest if the stock rises in value to exactly $55 before the option expires as long as Mike doesn’t exercise this option. If Mike does exercise the option, John gets to keep the $100 premium and receive $5,500 from Mike. Combined with the $100 premium; his total gain is $600.
However, if the ABC shares John bought become worthless (very unlikely), John would lose his initial investment of $5,000 even though he gets to keep the $100 Mike paid him. His total loss would be at $4,900.
In the event that ABC increases to $60 per share before the call option expires, Mike can exercise the option. He pays John $55 per share. John keeps the $100 premium and receives $5,500 from Mike for his 100 shares. His overall account value will be at $5,600.
However, John misses out on some potential gains because he could have sold his shares for $60 each. He could have made $6,000 instead of just $5,600. But the call he sold to Mike made him settle for just $55 per share, plus the $100 premium.
In this scenario. Mike would pay $5,500 for the shares that are now worth $6,000 so he would have a gain of $500.
Covered calls are a good strategy, and the best way to profit from stock while you hold it, but it requires attention to avoid capital loss.
Before exercising this strategy, it is important to understand the best time for the covered calls options and when it is unnecessary and risky, as explained in this article.