What Is Selling Covered Calls?
Learn how covered calls work as an options strategy to generate income or enhance returns on your stock holdings. Understand the process and management.
A covered call is an options strategy where an investor owns shares of a stock and simultaneously sells call options against those shares. This approach generates income through the premium received. It is useful for investors who hold stock and anticipate a stable or modest increase in value. The strategy aims to enhance returns on existing stock holdings.
Understanding Covered Call Elements
A covered call strategy begins with owning the underlying stock. An investor must possess at least 100 shares for each call option contract they intend to sell. This ownership makes the strategy “covered,” as the shares act as collateral to fulfill the obligation if the option is exercised.
A call option is a contract granting the buyer the right, but not the obligation, to purchase 100 shares of the underlying stock at a predetermined price, the strike price, on or before a specified expiration date. When an investor sells a call option, they sell this right to another party. In exchange, the investor receives an upfront payment, the premium.
The premium received from selling the call option provides income to the investor. This income can help offset potential losses if the stock price declines slightly, lowering the cost basis of the owned shares.
Placing a Covered Call Trade
To initiate a covered call trade, an investor first needs a brokerage account with options trading approval. Brokerage firms typically require specific authorization due to the inherent risks associated with options. Once approved, the investor selects a stock they either already own or intend to purchase concurrently with the option sale.
The next step involves choosing the specific call option contract to sell. This requires two decisions: the strike price and the expiration date. The strike price is the price at which the option buyer can purchase the shares, and it is commonly selected to be above the current market price of the stock, known as out-of-the-money. The expiration date is the point at which the option contract becomes void, with common timeframes ranging from weekly to monthly or quarterly cycles.
After determining the strike price and expiration date, the investor places a “sell to open” order through their brokerage platform. Investors typically set a limit price to ensure they receive their desired premium. Once the order is filled, the premium is credited directly to the investor’s account.
Outcomes and Management
The outcome of a covered call position largely depends on the stock’s price movement relative to the strike price by the expiration date. If the stock price remains below the strike price at expiration, the call option will typically expire worthless. In this scenario, the investor keeps the premium received and continues to own the underlying stock.
If the stock price rises above the strike price by expiration, the call option is likely to be assigned. This means the investor is obligated to sell their 100 shares per contract at the predetermined strike price to the option buyer. The investor still retains the premium from selling the option, but their upside profit from the stock’s appreciation is limited to the strike price. Early assignment can occur before the expiration date, particularly if the option is deep in-the-money and a dividend is approaching.
Investors can also actively manage an open covered call position. One common management technique is to “buy to close” the option before its expiration. This involves purchasing an identical call option to offset the one sold, closing the position. This action might be taken to realize profits if the option’s value has decreased, avoid potential assignment, or roll the position to a different strike price or expiration date.
Key Terminology
- Premium: This is the money an investor receives upfront for selling a call option. It represents the income generated by entering into a covered call agreement.
- Strike Price: The predetermined price at which the underlying stock can be bought by the option holder if they choose to exercise the option. For covered calls, the strike price is often set above the current market price of the stock.
- Expiration Date: The specific date on which the option contract becomes void. After this date, the option can no longer be exercised.
- In-the-Money (ITM): For a call option, this occurs when the underlying stock’s current market price is higher than the option’s strike price. An ITM call option has intrinsic value.
- Out-of-the-Money (OTM): For a call option, this means the underlying stock’s current market price is lower than the option’s strike price. An OTM call option has no intrinsic value.
- At-the-Money (ATM): This describes a call option where the underlying stock’s current market price is approximately equal to the option’s strike price.
- Assignment: This is the process where the seller of an option is obligated to fulfill the terms of the contract. In a covered call, assignment means the investor must sell their shares at the strike price.
- Covered: In the context of options, “covered” signifies that the investor selling the option owns the underlying asset (e.g., 100 shares of stock per contract) to back their obligation, reducing the risk compared to selling an “uncovered” or “naked” option.