How Does a Covered Call Work: Bullish Options Strategies
Stock investors can use options to improve their portfolio’s returns in various ways, such as hedging and income-generating strategies like the covered call.
For example, when the market is volatile and you expect it to go down, you can limit your losses by either buying put options or selling covered calls on your equity.
Since investors have a long-term bullish outlook on their investments, they generally do not want to sell them. Strategies like the covered call allow investors to protect their portfolios and hold their stock to avoid a taxable event.
How Does a Covered Call Work?
A covered call is a bullish options strategy that allows you to get paid in exchange for promising to sell your shares at a specific price. In other words, you can generate additional income, similar to dividends, by holding your shares of stock.
The covered call consists of two parts: 100 shares of a stock and a short call option. It is important to note that selling a call option is a bearish strategy, while owning 100 shares of a company is bullish.
However, if you buy 100 shares of a stock and immediately sell a call, the overall trade is bullish, meaning you benefit from a rise in the stock price. Unfortunately, many people do not realize that your covered call loses money when the stock moves up.
Covered Call Example
Let’s say buy you buy 100 shares of $AAPL at $120 per share. Then, you can sell a covered call with a strike price of $140 and promise to sell your shares in exchange for a premium. In this example, let’s say you can sell the $140 strike for $100 in premium.
Covered Call Example Breakdown:
100 shares of $AAPL at $120 per share
Sell -1 call with a strike price of $140, receive $100 in premium
There are a few scenarios that can happen with this covered call example. One example is that $AAPL doesn’t move, the call option expires, and you collect a $100 premium.
The next scenario is that shares of $AAPL skyrocket to $180 per share, and you must sell at $140 per share and miss out on some share appreciation. However, you will still keep the $100 of income, meaning you essentially sold the shares at $141.
Another example is that shares of $AAPL can drop hard and go to $70 per share. So you will be down $5,000 on your shares, and your covered call will only protect $100 since that is how much premium you collected.
Covered Call Risks
When you are trading options, you must be aware of the risks. For example, covered calls are relatively safe, but one of the risks is that the stock skyrockets, and you will miss out on a lot of gains.
However, you will see significant losses on your short call if the stock exceeds your strike price in your trading account. The shares cover all the losses and then some, but if you never sold the call option, you would have a higher account balance.
There is also an emotional risk involved since you may choose to close out your covered call at a loss, only to watch the stock fall back under the strike price shortly after. Therefore, you must be genuinely okay with selling your stock at the strike price you choose to avoid making a rash decision.
How Do I Pick a Strike Price for my Covered Call?
When picking a call option to sell, the most important rule is that you are okay with selling your stock at that price. However, you must accept the lower profit potential if the stock exceeds your strike price.
It is impossible to time when a stock will start coming down, but protection strategies like the covered call do not require perfect timing. Call options will lose value due to theta as time passes, even if the stock isn’t moving. Therefore, you can still make money with a covered call even if you time the stock wrong.
Stocks for Covered Calls
Since you must own at least 100 shares of stock to write a covered call, you may need to focus on lower-priced tickers. For example, if you have a $10,000 account, you must pick a stock worth $100 or less. You can also start by selling a cash-secured put with a strike price of $100 or less.
However, you should always research stocks before purchasing them. For example, it is not a good idea to buy shares of a stock just because it has a low share price. Instead, the safest way to practice would be to trade an ETF since you will be much more diversified than a single stock.
The Bottom Line for Selling Covered Calls
The covered call is a bullish options trading strategy where you promise to sell your shares in exchange for a premium. Covered calls are great for investors who want to hedge their stock portfolio or wish to generate income similar to dividends.
When you choose to sell a covered call, you must be okay with selling your shares because there is a chance you will lose them. However, if the stock doesn’t move or goes up slightly, you will generate a cash premium that you can use to purchase more shares or as income.
Additionally, you can use some of the premium you receive from selling the covered call to purchase put options. If the stock falls hard, you will limit your losses to the strike price of your put option.
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As Always: Buy things that pay you to own them.
-Josh
Blog Post: #053
