How to Make Money Selling Covered Calls

Covered Call Fundamentals

Selling covered calls is an income-generating strategy for investors who own shares of stock. The “covered” aspect means the investor owns the underlying stock, providing protection against significant losses if the stock price increases. This strategy is often employed in neutral or moderately bullish market conditions, where the stock price is not expected to experience large fluctuations.

A covered call involves several core components. First, the underlying stock, which the investor must own, typically in increments of 100 shares for each option contract sold. Second, a call option grants the buyer the right, but not the obligation, to purchase the underlying stock from the seller at a specified price. Third, the strike price is the predetermined price at which the stock can be bought if the option is exercised. Fourth, the expiration date marks the last day the option can be exercised. Finally, the premium is the immediate income the investor receives for selling the call option. By selling the call, the investor agrees to potentially sell their shares at the strike price on or before the expiration date in exchange for this upfront payment.

Choosing Your Underlying Asset and Option Contract

Selecting the appropriate underlying stock is a foundational step for covered call strategies. Investors often look for stable companies they are comfortable owning for the long term. Companies that pay dividends can be attractive, as the investor continues to receive dividend payments in addition to the option premium. It is also beneficial to choose stocks with moderate volatility, as extremely volatile stocks can lead to significant unrealized losses on the underlying shares, potentially offsetting the premium income.

Once a suitable stock is identified, the next decision involves choosing the specific call option to sell, which includes selecting both the strike price and the expiration date. The strike price directly impacts the premium received and the likelihood of the stock being called away. Selling an out-of-the-money (OTM) call, where the strike price is above the current market price, yields a lower premium but reduces the probability of the shares being sold. This approach allows for some potential stock appreciation before the cap is reached.

Conversely, selling an in-the-money (ITM) call, where the strike price is below the current market price, generates a higher premium but significantly increases the chance of assignment. An at-the-money (ATM) call, with a strike price near the current stock price, offers a balance, providing a decent premium with a moderate likelihood of assignment. The choice depends on whether the investor prefers to maximize premium income or retain the stock.

The expiration date also plays a significant role. Short-term options, typically 30 to 45 days until expiration, experience faster time decay, which benefits the option seller. This allows for more frequent income generation but requires more active management. Longer-term options offer larger upfront premiums but have slower time decay and tie up capital for a longer period.

Placing a Covered Call Order

To place a covered call order, the investor first identifies the symbol of the underlying stock. The account must hold at least 100 shares of the chosen stock for each option contract intended to be sold.

Within the options chain, the investor selects the desired expiration date and strike price. The number of contracts to sell is then entered. A limit order is common for options, allowing the investor to specify the minimum price they are willing to accept for selling the option.

Trade Outcomes and Management

After a covered call order is placed, several outcomes are possible as the expiration date approaches. If the stock price remains below the strike price at expiration, the call option expires worthless. The investor retains both the underlying shares and the full premium collected. This outcome allows the investor to potentially sell another covered call on the same shares, continuing the income generation.

If the stock price rises above the strike price by the expiration date, the option is assigned. The investor’s shares are sold at the predetermined strike price. The total profit in this scenario includes the premium received from selling the call option plus any capital appreciation of the stock up to the strike price.

If the stock price declines significantly after the covered call is sold, the premium received offers a limited buffer against losses. A substantial drop in the stock’s value can result in a loss on the underlying shares that outweighs the premium income. In such a situation, the option will likely expire worthless, but the investor will still hold the depreciated stock.

Investors can employ various management strategies to adapt to changing market conditions before expiration. One common approach is “rolling” the option, which involves buying back the current call option and simultaneously selling a new call option with a different strike price or a later expiration date. This allows investors to adjust their position, potentially collect additional premium, or avoid having their shares called away if they wish to retain the stock.