The covered call strategy is a great strategy for many investors of both beginner and expert skill level. In most scenarios investors can make money in sideways, falling, and rising markets. I personally have used the covered call strategy countless times to take advantage of market fluctuations. I have talked previously about covered calls when I wrote about how to generate income from your portfolio, but here I will focus on covered calls alone.
To write a covered call, an investor must first own the underlying stock to write the call against. A call option gives the buyer of the call option the right to purchase the underlying stock at the strike price of the call option on or before expiration. Therefore, it is possible that the writer of the call option could have his or her stock called away. Owning the underlying stock “covers” the call option, thus this strategy is called writing a covered call. The investor who is writing, or selling, the call option gets to choose the expiration date and the strike price. Each call option controls 100 shares of underlying stock. Let’s take a look at an example.
An investor owns 1,000 shares of BP that he or she bought at an average price of $16.50. He decides to sell 10 covered calls against this position. It is December 21st, 2020 and he wants the calls to expire on January 15th, 2021 with a strike price of $22.00. Looking at a recent quote for the January 15 expirations, he could sell each option for $41.00, or a total of $410. That money is his to keep no matter what. He can reinvest it, use it to buy a new TV, or whatever he pleases. That is one of the perks of selling covered calls; the investor gets to collect nice premiums. Also, the investor keeps receiving the dividends as long as the shares do not get called away. The dividend yield on BP at $16.50 is around 7.6% which is a nice little dividend every quarter. After writing the call and receiving the $410 a few scenarios could potentially take place until the December expiration…
Scenario #1:
January 15 rolls around and the share price of BP is $24.00. The 1,000 shares of BP get called away at $22.00 because that was the strike price of the covered calls. This highlights one of the disadvantages of writing covered calls. You have limited your upside to $22.00, and you have missed out on the ride up to $24.00. However, you still had a nice gain by selling at $22.00. You have locked in a 33.3% return on your shares, or $5,500, and you have also collected $410 in premiums and $315 in quarterly dividends for a total of $6225.00. This is a total return of 37.7%.
Scenario #2:
January 15 rolls around and the share price of BP is below $22.00 sitting at $20.00. The 1,000 shares of BP are not called away, and you will still be the owner of the shares and you will still receive dividend payments. Covered calls work fantastic in a sideways market like this because you now get to sell 10 new call options against your BP shares! This means that you get to collect another $410 potentially depending on the price of the call option at the time, expiration, and strike price. This is called rolling over your call options, and it can generate a lot of extra cash over the course of a year.
Scenario 3:
Before the calls expire, the share price of BP rises to $22.50. The ex-dividend date is approaching. Your shares get called away at $22.00 before expiration. This is similar to Scenario #1 with the exception that you will not receive the dividend payment for the quarter because you did not own the shares on the ex-dividend date. In my experience if the share price is above the strike price of the option, it is not unusual for the buyer of the call to exercise the call option before the expiration date if the ex-dividend date is coming up for a stock. They do this in order to receive the dividend for the stock.
As you can see, selling covered calls is a great way to generate premiums, or a monthly income, and it can be a great strategy for any market if you are willing to limit your upside. By far the biggest risk of selling covered calls is missing out on a massive run up in the stock price during a bull market.
Three major factors affect options prices: volatility, time until expiration, and how far the share price is from the strike price. Knowing these factors can be used to your advantage. If market volatility spikes for a few days, then consider selling some covered calls to take advantage of the now inflated prices of call options. Since you are selling call options, investors will be willing to pay more to buy them from you!
This article covers the very basics of the covered call strategy. It is a beautiful strategy because it is so simple yet so effective in many cases. Because you are getting paid to sell your stock at a certain price, many investors say you are getting paid to sell your shares. Another common thing to hear from die-hard option users is never sell your shares for free. Of course, there is a time and place for every strategy, and this one may not always be optimal. However, you should definitely consider it if you want a monthly income and don’t mind potentially missing out on some upside profit.
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