Should I Sell Covered Calls to Generate Income?

Selling covered calls is a strategy for investors to generate income from existing stock portfolios. This approach involves a specific options contract, allowing individuals to collect premiums while holding shares. Understanding covered calls is important for those considering this income-generating method.

Core Components and Mechanics

A covered call strategy involves owning 100 shares of a stock and simultaneously selling one call option contract against those shares. The term “covered” means the investor owns the shares needed to fulfill the option’s obligation. When selling a call option, the investor receives an immediate payment, called a premium, from the buyer. In exchange, the seller grants the buyer the right, but not the obligation, to purchase the 100 shares at a predetermined strike price before a specific expiration date. One options contract covers 100 shares.

Understanding Potential Scenarios

Several outcomes are possible after selling a covered call, depending on the stock’s price movement relative to the strike price. Understanding these possibilities helps in managing expectations and planning subsequent actions.

If the stock price remains below the strike price at expiration, the call option expires “out-of-the-money” and becomes worthless. The seller retains ownership of their shares and keeps the entire premium. This allows the investor to potentially sell another covered call and generate additional income.

If the stock price rises above the strike price at or before expiration, the option becomes “in-the-money” and is likely to be assigned. Assignment obligates the seller to sell their shares at the strike price. The seller keeps the initial premium, and the shares are sold. For tax purposes, if a covered call is assigned, the premium received is added to the sale price of the stock to determine the capital gain or loss.

Investors can also close their position before expiration by “buying to close” the option. This involves purchasing an identical call option to offset the one originally sold. If the option’s value has decreased, buying it back at a lower price allows the investor to lock in a profit on the option component and retain stock ownership. If the option is closed early, any net capital gain or loss from the option is generally considered short-term for tax purposes.

Essential Decision Points

Before initiating a covered call trade, investors must make several important decisions that influence the potential outcomes and suitability of the strategy for their financial objectives. These considerations involve selecting the appropriate underlying stock, determining the strike price, and choosing an expiration date. Each decision carries specific implications for the premium received and the probability of the shares being assigned.

Selecting an appropriate underlying stock is a foundational step. Ideal candidates for covered calls are typically companies with stable to moderately bullish outlooks, rather than highly volatile stocks. Companies that pay dividends can be particularly attractive, as the covered call seller continues to receive dividend payments while owning the shares, in addition to the option premium.

It is generally advisable to choose stocks that an investor is comfortable owning for the long term, even if the option expires worthless, or selling at the strike price if assigned.

The choice of strike price significantly impacts both the premium collected and the likelihood of assignment. Selling an “out-of-the-money” (OTM) call, where the strike price is above the current market price, typically yields a smaller premium but offers a higher probability of the option expiring worthless, allowing the investor to keep the shares. Conversely, an “at-the-money” (ATM) call, with a strike price near the current stock price, or an “in-the-money” (ITM) call, with a strike price below the current price, will generate a larger premium but increases the chance of assignment. The selected strike price should align with the investor’s outlook on the stock’s future price movement and their willingness to sell the shares.

Determining the expiration date involves a trade-off between premium size and time horizon. Options with longer expiration periods generally command higher premiums due to more time for the underlying stock price to move. However, shorter-term options experience faster time decay, which can be advantageous for the seller if the goal is to have the option expire worthless. Many covered call strategies focus on shorter-term options, often ranging from a few weeks to a few months, to frequently collect premiums.

Finally, a fundamental requirement for selling covered calls is the direct ownership of 100 shares of the underlying stock for each contract sold. This means a significant capital commitment is necessary to establish the “covered” position. For instance, if a stock trades at $50 per share, an investor needs $5,000 to purchase 100 shares before selling a single covered call contract. Brokerage firms typically charge fees for options trades, which can include a per-contract fee in addition to a base commission, and sometimes an assignment fee if the option is exercised. These costs should be factored into the potential income generation.

Managing an Open Position

Once a covered call trade has been initiated, ongoing management is important to adapt to market changes and optimize outcomes. The dynamic nature of stock and option prices means that a set-it-and-forget-it approach may not yield the best results. Active monitoring and strategic adjustments can help in navigating various market conditions.

Consistent monitoring of the underlying stock price, the option’s premium, and the time remaining until expiration is important. The value of the option premium erodes as it approaches its expiration date, a phenomenon known as time decay. Tracking these factors helps in making informed decisions about whether to let the option expire, close it early, or adjust the position. Staying informed about company-specific news or broader market events that could impact the stock’s price is also beneficial.

Investors have several strategies to adjust an open covered call position. One common adjustment is “rolling” the option, which involves buying back the current call option to close it and simultaneously selling a new call option, often with a different strike price or a later expiration date. Rolling “up” means selling a new option with a higher strike price, often done when the stock price has risen, to capture more potential upside while still collecting a premium. Rolling “out” involves extending the expiration date, which can be useful to collect additional premium if the stock is trading sideways or to give the stock more time to move below the strike price. Rolling “up and out” combines both adjustments, aiming to secure more premium and potentially higher gains.

If the option is in-the-money and assignment appears likely, and the investor wishes to retain the shares, buying back the call option is the primary method to prevent assignment. However, if the investor is comfortable selling the shares at the strike price, they can allow the assignment to occur. When a covered call is assigned, the brokerage firm handles the procedural steps of selling the shares from the investor’s account at the strike price. For tax purposes, the sale of the stock due to assignment is treated like any other stock sale, with capital gains or losses determined by the difference between the stock’s cost basis and the effective sale price (strike price plus premium received).