5 Essential Tips to Sell Covered Calls
Everyone wants to make money, but generating income in this low-yield environment can be challenging. Any savvy investor would like to maximize their stock portfolio for more returns. That's why smart investors love covered calls.
Selling covered calls can be a fantastic investment strategy. However, many people cheat themselves out of potential profit or open themselves up to risks they don't anticipate because they don't know how to sell a covered call properly.
This article will cover the basics of covered calls and useful tips on how to sell covered calls. Upon reading this article, you'll better appreciate basic terms such as stock price and expiration date.
The basics of a covered call
Before making money out of a covered call, you need to understand the basics. You use a covered call when an investor sells call options against the stock already in their possession or bought for that transaction specifically.
A covered call is an investment strategy that involves traders selling call options. In this transaction, you can buy against stock you already have or have purchased recently to make extra income from those shares. The option you sell is considered covered because you have enough shares to cover the transaction costs required by the option you've sold.
Through covered call strategies, investors can earn income, but they can also hinder potential gains from the upside potential of their stock price. Knowing how a covered call strategy works can help determine if you should implement one.
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Why is this call option called covered?
The term 'covered' in this investment simply means the call option seller already owns at least a hundred shares of the underlying stock that they are selling the call option on.
What is a covered call strategy?
A covered call is used when an investor sells call options against stock they already have in their possession or bought for that particular transaction. When you sell a call option, you give the call option buyer the right to buy the underlying stock at a given price and time. This strategy is deemed as 'covered' because you already possess the stock to be sold to the buyer when they exercise it.
A covered call involves two steps. The first step involves you buying the share price of the stock. You can select the stock using any method of your preference. As with any investment, you should do your due diligence. Covered call strategies work well with stocks that are not volatile and are known for their stability.
The second step involves selling call options against the stock you bought. Call options give the buyer the right, but not the obligation, to purchase shares at a set price. The buyer must pay a premium fee when you sell the option during a covered call. You get to generate income from selling the option. Each option contract usually involves a hundred shares.
How does a covered call strategy work?
A covered call is a popular covered call strategy. This strategy is considered low-risk, as compared to others. Why? A covered call position allows you to generate income from your existing portfolio. Many brokerage firms will allow selling covered calls even in accounts not authorized to trade other options.
The main reason why a covered call is considered low risk is that the loss you can incur from this strategy can be limited. With other options contracts, you can be exposed to potentially infinite risk.
You're not just protecting yourself from losing money when you're involved in covered calls. You also limit how much you can earn from a stock price increase. In return, you receive income from a premium paid by the option buyer.
How profitable is selling covered calls?
Despite the volatility of the stock market, covered call writing is still one of the most conservative income trading strategies that smart investors use in order to make additional weekly or monthly income.
In general, investors can earn an average between 1% to 5% (or more) selling covered calls. How much you earn exactly from this strategy would depend entirely on the volatility of the stock market, the strike price, and the expiration date. The general rule is that the more volatile the markets are, the higher the monthly income you'll get to earn from this investment tool. At the same time, you may have to sell calls with a longer expiration date if the markets are calmer.
Can you lose money while selling covered calls?
The good news is that as a conservative strategy, you'll never really lose money by collecting the income from selling the covered call. However, if the equity loses value and you still sell it at a loss, you may incur a loss in the process. Given that the stock is yours, to begin with, the losses may be minimal.
How do you calculate the returns from a covered call?
As a smart investor, you would want to know how much you might be gaining from this transaction. There are two returns you should know about. The first is the total return. This refers to the amount of income divided by the stock price.
The other return you should be aware of is the annualized return. You can compute this amount by multiplying the options income x 365 days x 100. You then divide this amount by the stock price multiplied by the weeks left for the call option expiration.
When should you sell a covered call?
When you're selling a covered call, you make money in exchange for giving up a portion of the future upside. For example, let's say you purchased stock 123 for a price of $50 per share while believing that its value would rise to $60 within the next year. You're also willing to sell that share for $55 within the next six months, giving up the possibility that it might grow within that period for a conservative profit. In this scenario, it would be a smart decision to sell a covered call.
The stock's option chain indicates that selling a call option at $55 for a six-month contract will cost the buyer $4 per share. You have the option to sell that option against your shares, which you initially bought at $50 and intend to sell at $60 within a year. Writing this covered call creates for you an obligation to sell their shares at $55 within the next six months if the underlying price reaches that level. At the end of the day, you get to pocket the $4 in premium in addition to the $55 from the share sale. You end up with a total of $58, or an 18% return over the next six months.
Tips on how to sell covered calls
As with any investment strategy, covered calls involve some rules. Here are some tips for structuring more effective covered call investments:
1. Don't sell a covered call on a stock you intend to hold on to. When selling covered calls, you make it clear that you're willing to keep holding your stock even if the underlying stock falls. If the stock price drops dramatically, your profit from this type of transaction gets affected.
At the same time, you wouldn't want it to rise. If the stock price rises, you may incur more losses than gains because you forfeit the upside potential of that stock. This is why you should be in a stock position with good standing when you're involved in a covered call.
If the stock is called away, you'll end up losing that stock. Then, you would have to pay capital gains tax. You may even have to purchase that particular stock again if you want to own it again in the future.
When it comes to this investment strategy, it would be ideal to involve only stocks that are known for their stability. You wouldn't want to sell calls on a volatile stock because the current market price affects your overall income.
As a stock investor, you already have a lot on your plate as you would want to keep your taxes at a minimum. It would be best if you didn't give yourself more things to worry about by selling calling on a favorite stock. When the stock price remains the same, you end up gaining more money through a covered call without risking your initial investment.
2. Don't sell a covered call on a stock you would want to own yourself. Once you've agreed to participate in this type of transaction, you accept its implications, such as the strike price and expiration date. These implications include the willingness to accept downside risk, so you must be willing to accept all the risks involved. After all, there is no such thing as a free lunch.
Options for small and up-and-coming companies are expensive, so selling a covered call on stocks like these may be enticing. However, covered calls on these types of companies involve you paying a high premium. This is the same principle as to why automotive insurance for 17-year-old boys would be more expensive.
To put things into perspective, the act of screening options with high implied volatilities in order to find the juiciest premiums will most likely mean you'll have to pay for more than your stock share. You may also end up investing more money than intended in the process. Hence, your goal should be to find a stable stock.
3. You should sell at-the-money call options. Most people would normally sell out-of-the-money (OTM) calls because they fear that the stock would be called away. An OTM is an option that has no intrinsic value. It means that the underlying price is trading below the call strike price.
In general, OTMs are much cheaper to buy, making them ideal for investors who want to make the most out of their money through stock upsides. However, this isn't the case if you're involved in a covered call. If you've followed the first tip explained above, you wouldn't really care if that stock is called away.
At-the-money (ATM) calls pay the most significant premium for the risk you're willing to accept. ATMs are calls and puts whose strike prices are at or very close to the current market price of the underlying security. ATM options are most vulnerable to changes in several risk factors. These may include time decay and changes to implied volatility or interest rates. You should buy low by writing at-the-money calls when involved in this investment tool.
4. Search for shorter tenor-covered calls to sell. While you may receive more profit in the form of a premium when you sell more extended tenor options, the premium amount you receive per day decreases. Just a quick refresher, tenor refers to the time until the maturity of a loan or the time until the expiration date for derivatives. The stock market can be incredibly unpredictable, and you never know what tomorrow may bring.
It would be best to look for options with two to three months left before the expiration date. This range of tenors helps you strike a good balance between a low effective buy price and a high premium per day. At the end of the day, your goal should be to maximize your yields from this strategy while keeping the stock in your portfolio.
5. Keep calm if a stock you wrote a covered call recently drops. For most people, selling ATM options at the new lower stock price would be practical. However, you should resist this temptation if you don't want to lose more than you gain.
If you sold calls at a higher stock price, then sell it again for a lower strike price, you end up buying high and selling low. At the end of the day, this is not a recipe for investing success.