How Much Can You Make Selling Covered Calls?

A covered call involves holding shares of a stock while simultaneously selling call options against those shares. This strategy allows an investor to generate income from their stock holdings. The core idea is to collect a payment, known as a premium, for the commitment to sell shares at a predetermined price if the stock reaches that level by a specific date. This article explores the potential income generated from this options strategy.

Sources of Income from Covered Calls

The primary source of income from selling covered calls is the premium received. This cash payment is compensation for granting the option buyer the right to purchase the underlying shares at a specified price, known as the strike price, before the option’s expiration date.

The premium is received upfront. If the option expires worthless, the seller retains the entire premium as profit, and the underlying shares remain in their possession.

Another source of income arises if the option is exercised. If the strike price is higher than the original purchase price of the stock, the difference between the strike price and the cost basis of the shares contributes to the overall profit. This capital appreciation, combined with the initial premium, forms the total return when the option is exercised.

Factors Affecting Covered Call Premiums

The amount of premium an investor receives for selling a covered call is influenced by several factors, each contributing to the option’s value. Understanding these elements helps in estimating potential income.

Stock price volatility is a key determinant of option premiums. Higher expected volatility in the underlying stock leads to higher call premiums because there is a greater chance the stock price will move significantly, potentially exceeding the strike price. This makes the option more valuable to the buyer.

The time remaining until the option’s expiration date directly impacts the premium. Options with longer times to expiration command higher premiums, as a longer timeframe provides more opportunities for the stock to move and accounts for time value. As an option approaches expiration, its time value erodes, known as theta decay, which causes the premium to decrease.

The selection of the strike price relative to the current market price of the underlying stock plays a key role in the premium received. Options that are “in-the-money” (current stock price is above the strike price) or “at-the-money” (current stock price is equal to the strike price) yield higher premiums due to their intrinsic value or higher probability of expiring in the money. Conversely, “out-of-the-money” options (current stock price is below the strike price) offer lower premiums because they only possess extrinsic or time value and have a lower probability of being exercised.

The current price of the underlying stock also influences the premium, particularly its intrinsic value component if the option is in-the-money. Higher stock prices correlate with higher premiums for calls, especially for those at or near the money. Interest rates can have a minor effect; higher interest rates can increase call option premiums due to the cost of carrying the underlying asset. Similarly, upcoming dividend payments can decrease call premiums, as the stock price typically drops on the ex-dividend date.

Determining Profit in Various Market Conditions

The actual profit realized from a covered call strategy depends on how the underlying stock performs relative to the chosen strike price by the option’s expiration date. Different market conditions lead to distinct outcomes for the covered call seller.

If the stock price rises above the strike price by expiration, the call option will be exercised. The investor is obligated to sell their shares at the strike price. The profit consists of the premium received, plus any capital appreciation of the stock from its purchase price up to the strike price. The maximum profit for a covered call occurs when the stock price is at or above the strike price at expiration.

Conversely, if the stock price remains below the strike price at expiration, the call option will expire worthless. In this case, the investor retains both the premium received and ownership of the shares. The profit from the trade is simply the premium collected. However, if the stock price has declined below the original purchase price, the unrealized loss on the stock itself could exceed the premium received, resulting in an overall net loss.

If the stock price is at or near the strike price at expiration, the outcome can vary. If the stock finishes slightly above the strike, the option may be exercised. If it finishes slightly below, it will expire worthless. In scenarios where the stock trades around the strike price, the seller might choose to buy back the option to avoid assignment or let it expire.

When a covered call is exercised, the sale of the stock is treated as a capital gain or loss. If the stock was held for more than one year before the exercise date, any gain on the stock sale would be considered a long-term capital gain, taxed at lower rates. If held for less than one year, it would be a short-term capital gain, taxed at ordinary income rates.

Calculating Your Covered Call Return

Quantifying the potential earnings from covered calls involves calculating the percentage return, which provides a clear measure of profitability relative to the capital invested. These calculations help investors compare the effectiveness of different covered call opportunities.

A simple way to calculate the return on capital from a covered call, assuming the option expires worthless, is to divide the premium received by the cost of the 100 shares of stock. For example, if an investor sells a call option for a $1.50 premium per share (totaling $150 for 100 shares) and the 100 shares cost $5,000, the simple return would be ($150 / $5,000) 100 = 3%.

If the option is exercised, the return calculation needs to account for both the premium and any appreciation of the stock up to the strike price. The formula is (Premium + (Strike Price – Stock Purchase Price)) / (Stock Purchase Price) 100. For instance, if the stock was purchased at $50 per share, a call was sold for a $1.50 premium with a strike price of $55, and the option is exercised, the return would be ($1.50 + ($55 – $50)) / $50 100 = ($1.50 + $5) / $50 100 = $6.50 / $50 100 = 13%.

For comparing returns across different timeframes, an annualized return can be estimated. This involves taking the simple return on capital, dividing it by the number of days until expiration, and then multiplying by 365. For example, if a 3% return was achieved over a 30-day period, the annualized return would be (3% / 30) 365 = 36.5%. These calculations represent gross returns and do not account for potential brokerage commissions or tax liabilities, which would reduce the net profit.