How to Sell Covered Calls for Income

Covered calls offer a strategy for stock investors to generate income. This approach involves owning shares of a stock and simultaneously selling a specific type of option contract against those shares. The primary goal is to collect cash payments, known as premiums. This can be particularly appealing in market conditions where stock prices are not expected to rise significantly, or when an investor seeks to enhance returns on existing stock holdings.

Understanding Covered Calls

A covered call strategy involves owning at least 100 shares of a specific stock and selling one call option contract for every 100 shares owned. The term “covered” signifies that the investor already possesses the underlying shares, which act as collateral for the potential obligation to sell them. This contrasts with “naked” call selling, which carries unlimited risk.

When an investor sells a call option, they grant the buyer the right to purchase their 100 shares of the underlying stock at a predetermined price, on or before a specific expiration date. In exchange for granting this right, the seller immediately receives a cash payment, the premium.

The relationship between the strike price and the current stock price defines the option’s moneyness. An option is “in-the-money” (ITM) if the stock price is above the strike price. Conversely, it is “out-of-the-money” (OTM) if the stock price is below the strike price, and “at-the-money” (ATM) if the stock price is equal to or very close to the strike price.

The premium received is the maximum profit from the option if the option expires worthless. If the option expires ITM, the shares may be “called away” or assigned. This caps the potential upside profit on the stock at the strike price, plus the premium received.

Prerequisites and Preparation

Before engaging in covered call trading, investors must ensure their brokerage account is approved for options trading, which often requires a specific options trading level.

A fundamental requirement for a covered call is owning at least 100 shares of the underlying stock for each option contract intended to be sold. Without owning these shares, selling a call option would expose the investor to potentially unlimited risk.

Researching the underlying stock is important, focusing on factors like volatility and liquidity. A stock with moderate volatility may offer attractive premiums without excessive price swings, while high liquidity ensures efficient entry and exit from positions. It is also beneficial to have a personal conviction in holding the stock long-term.

Selecting the strike price involves a trade-off between the premium received and the potential for stock appreciation. Choosing an out-of-the-money strike price reduces the likelihood of assignment and allows for some stock appreciation. This typically results in a lower premium. Conversely, an at-the-money or slightly in-the-money strike price yields a higher premium but increases the probability of assignment and limits potential stock gains.

Choosing the expiration date is another crucial decision, influenced by the concept of time decay, where an option’s value erodes as it approaches expiration. Short-term options, often 30 to 45 days until expiration, experience faster time decay, which benefits the seller as the option loses value more quickly. This allows for more frequent income generation, but also requires more active management. Longer-term options generally offer larger premiums but they decay slower and tie up the capital for a longer period.

Executing a Covered Call Trade

Once the underlying stock, strike price, and expiration date have been selected, the next step involves placing the covered call order through a brokerage platform. This typically begins by logging into the brokerage account and navigating to the options trading interface, which might be labeled “Trade” or “Options Chain.” The options chain displays available call and put options for the chosen stock, organized by expiration date and strike price.

From the options chain, the investor identifies the specific call option that matches their chosen strike price and expiration date. To sell a covered call, the action selected is “Sell to Open.” This instructs the brokerage to initiate a new short options position. It is crucial to distinguish “Sell to Open” from “Sell to Close,” which is used to exit an existing short position.

The quantity of contracts to sell must correspond to the number of shares owned, with one contract representing 100 shares. For example, if an investor owns 500 shares, they would sell five call option contracts. The order type is typically a “Limit Order,” allowing the investor to specify the minimum premium they are willing to receive for the option. This ensures the trade only executes at a price favorable to the seller, unlike a “Market Order” which executes immediately at the prevailing price.

After inputting the quantity and limit price, the investor should carefully review all order details on the confirmation screen before submitting the trade. This review ensures accuracy in the stock symbol, strike price, expiration date, number of contracts, and the premium to be received. Upon submission, the brokerage platform will typically provide an order confirmation and update the account’s positions to reflect the newly sold covered call. Transaction fees for options trading typically range from $0.50 to $1.00 per contract, in addition to small regulatory fees imposed by exchanges and governing bodies.

Managing Covered Call Positions

After a covered call trade is executed, continuous monitoring of the position is important. This involves tracking the underlying stock’s price, the call option’s premium value, and the remaining time until expiration. The value of the option will decay over time, a phenomenon known as theta, which generally benefits the option seller.

At the option’s expiration date, two primary outcomes are possible. If the stock price remains below the strike price, the call option will expire “worthless.” In this scenario, the investor retains the shares and keeps the entire premium received, which is treated as a short-term capital gain for tax purposes, regardless of the stock’s holding period. The investor is then free to sell another covered call on the same shares if desired.

The second outcome is “assignment,” which occurs if the stock price is at or above the strike price at expiration. In this case, the option buyer will exercise their right, obligating the seller to sell their 100 shares per contract at the specified strike price. The premium received is added to the sale price of the stock when calculating capital gains or losses. The tax treatment of the stock sale depends on the holding period of the shares, with gains on shares held for more than one year potentially qualifying for more favorable long-term capital gains rates.

Investors also have options to manage their positions before expiration. One action is to “buy to close” the option, which involves purchasing the same call option that was originally sold. This effectively cancels the obligation and allows the investor to exit the position early. This might be done to lock in profits if the premium has significantly decayed, or to avoid assignment if the stock price has risen considerably and the investor wishes to retain their shares. Another strategy is “rolling the option,” which involves buying back the current option and simultaneously selling a new option with a different strike price, expiration date, or both. This allows the investor to extend the trade, potentially collect more premium, or adjust the strike price in response to stock movements, without having their shares called away.