Covered Call

A covered call involves selling a call option on a stock you own, giving someone else the right to buy your stock at a specified price (strike price) by a certain date (expiration). Because you own the underlying stock, the call is “covered,” minimizing the risk of the obligation.

Key Characteristics:

• Obligation to Sell: If the option is exercised, you must sell your shares at the strike price.
• Premium Income: You earn a premium upfront for selling the call option.
• Stock Ownership: You retain ownership of the stock unless the option is exercised.

Why Use This Strategy?

1. Generate Income: Earn premiums from stocks you already own, adding to your total return.
2. Manage Risk: The premium provides a small buffer against declines in the stock price.
3. Optimize Returns: Suitable for stocks you believe will trade sideways or rise modestly.

How Covered Calls Work

1. Own the Stock: Start with at least 100 shares of a stock you’d like to sell calls on.
2. Sell the Call Option: Select a strike price and expiration date, and sell a call option.
3. Collect the Premium: Receive cash upfront for taking on the obligation.

Key Metrics

• Premium Yield:
  Premium Yield = (Premium Collected / Stock Price) × 100%
  Example: A $2.00 premium on a $100 stock generates a 2% yield.
• Break-Even Price:
  Break-Even = Stock Price – Premium Collected
  Example: If you own a $100 stock and sell a call for $2.00, your break-even is $98.00.
• Maximum Profit:
  Max Profit = (Strike Price – Purchase Price) + Premium Collected

Example of Selling a Covered Call

• Stock: XYZ
• Current Price: $50
• Strike Price: $55
• Premium: $2.00

Possible Outcomes:

1. Stock Price Stays Below $55 (Call Expires Worthless):
   • The option expires worthless, and you keep the $2.00 premium.
   • You still own the stock, which you can sell another call on.
2. Stock Price Exceeds $55 (Call Exercised):
   • You must sell your shares at $55, regardless of how high the stock price rises.
   • Total profit:
     ($55 – $50) × 100 shares + $200 premium = $700 profit.
3. Stock Price Declines Below $50:
   • The call expires worthless, and you keep the $2.00 premium.
   • Your unrealized stock loss is partially offset by the premium.

Benefits of Selling Covered Calls

1. Generate Income: Earn premiums even if the stock price doesn’t move.
2. Reduce Downside Risk: The premium acts as a small buffer against stock price declines.
3. Enhance Total Returns: Combine stock appreciation and premium income for higher returns in sideways or modestly bullish markets.
4. Customizable Risk: Adjust strike prices and expiration dates to fit your risk tolerance and goals.

Risks of Selling Covered Calls

1. Limited Upside: If the stock price rises significantly, your profit is capped at the strike price plus the premium.
2. Stock Price Decline: If the stock price falls sharply, your losses on the stock could outweigh the premium received.
3. Opportunity Cost: If the stock surges beyond the strike price, you miss out on potential gains.

When to Use Covered Calls

1. Neutral to Slightly Bullish Outlook:
   • Use this strategy if you believe the stock price will rise modestly or stay flat.
2. Low Volatility Stocks:
   • Covered calls work best with stocks that have stable, predictable price movements.
3. Generate Income on Long-Term Holdings:
   • Monetize stocks you intend to hold for the long term.

Selecting Strike Prices and Expirations

1. Strike Price:
   • Choose a price above the current stock price where you’d be comfortable selling the stock.
     • Higher Strike Price: Lower premium but less risk of assignment.
     • Lower Strike Price: Higher premium but greater chance of selling the stock.
2. Expiration Date:
   • Shorter expirations (1-4 weeks) provide faster income and flexibility.
   • Longer expirations (1-3 months) lock in larger premiums but reduce flexibility.

Advanced Strategies With Covered Calls

1. Rolling Calls:
   • If the stock approaches the strike price, “roll” the call by buying it back and selling a new one with a later expiration or higher strike price.
2. Covered Call ETFs:
   • Consider ETFs like JEPI or XYLD that implement covered call strategies for passive investors.
3. Use With Dividend Stocks:
   • Collect dividends alongside premium income for a double income stream.

Example of Rolling a Covered Call

1. Initial Call:
   • Stock: XYZ at $50
   • Strike Price: $55
   • Premium: $2.00
2. Rolling:
   • Stock rises to $54 before expiration.
   • Buy back the $55 call for $1.00 and sell a new $57 call for $1.50.
   • Net premium: $0.50 from the roll + $2.00 from the original call.

Tips for Successful Covered Calls

1. Use Quality Stocks:
   • Choose stable, fundamentally strong companies to reduce downside risk.
2. Monitor Volatility:
   • Higher volatility stocks offer larger premiums but come with more risk.
3. Diversify:
   • Spread your covered call strategy across multiple stocks or sectors.
4. Avoid Earnings Announcements:
   • Stock price volatility increases during earnings, raising the risk of assignment.

Conclusion

Selling covered calls is a reliable strategy for generating income and reducing risk in your portfolio. By selecting the right stocks, strike prices, and expirations, you can maximize returns while protecting against moderate declines. This strategy works well in sideways or modestly bullish markets and can be a valuable tool for long-term investors.