How to Sell Covered Calls: The Ultimate Guide

Selling call options as part of an investment plan is a covered call strategy. It is the right to purchase shares of stock you already own or recently bought to increase the income you receive from those shares. Although covered call methods might limit gains from stock price increases, they assist investors in generating income.

Introduction

A covered call is a two-step technique in which calls are sold on a share-for-share basis while stock is bought or owned. The practise of simultaneously purchasing stock and selling calls is referred to as "buy writing." The act of selling calls against previously bought shares is referred to as a "overwrite."

An investor who purchases 500 shares of stock while simultaneously selling 5 call options is said to be engaging in a buy-write strategy. When a shareholder decides to sell five calls in opposition to 500 shares that they have long owned, this is known as a "overwrite." The resulting position is known as a "covered call position," regardless of whether the shares are bought first and then the calls are sold.

Professional market participant’s use covered calls to increase investment income, but if amateur investors take the time to understand how they operate and when to use them, they may also gain from this conservative but powerful option strategy. Let's investigate how the covered call might reduce portfolio risk and boost investment returns in this area.

A common option strategy for individual investors, covered call writing (CCW), has attracted the attention of managers of exchange-traded funds (ETFs) and mutual funds due to its high level of success. In essence, when you write a covered call, you are giving someone else the right to buy your stock within a given time frame and at a certain price. You sell someone else the right to buy a stock that you already own, at a set price, within a given time frame when you write a covered call. To use this technique, you must own at least 100 shares for each call contract you intend to sell because one option contract typically equals 100 shares.

You will immediately receive the premium by selling (or "writing") the call. You are protected if the stock price increases over the strike price and the call options are issued because you already own the stock. Simply deliver the stock you already possess to benefit from the stock's increase in value. Many investors start trading options using covered calls. Although there are significant dangers, holding the stock rather than selling the call carries the majority of the risk. The option's sale only reduces opportunities for gains.

Running a covered call allows you to benefit from the expiration of the options you sold. The call you sold will lose value each day the stock remains unchanged, which is advantageous to you as the seller. (The idea of time decay is crucial. Therefore, seeing it in use is beneficial for you as a beginning.) Your shares won't be called away as long as the stock price stays below the strike price. In principle, you could continue using this method on the same stock piece indefinitely. Additionally, as you run more covered calls, you'll gain more understanding of how the option market functions.

You could also think you sound wiser when you gaze in the mirror. But we're not committing to anything. When you gaze in the mirror, you could also think you sound wiser. But we do not promise anything in that regard.

What Is A Covered Call?

As the owner of the stock or a futures contract, you have a number of rights, including the ability to sell the security whenever you want for the going rate. The right to own your security at a predetermined price known as the strike price on or before the expiration date is sold to a third party in exchange for cash through covered call writing.

A call option is a contract that offers the buyer the freedom of the right, at any time during the term, at the strike price, to purchase 100 shares of the underlying stock or one future contract or before expiration without incurring any financial commitment.

 The option is deemed "covered" if the call option seller also owns the underlying security since they can deliver the asset without having to buy it on the open market at perhaps unfavorable pricing.

Conversely, people who sell calls and really own the underlying shares are "covered" since they can just deliver the shares they already have to fulfill an exercise commitment. Because of this, covered call sellers (writers) are in a very different situation than uncovered call sellers. The covered call writer ensures they can fulfill an option exercise commitment by owning the underlying shares, regardless of where the stock price may go. As long as they don't sell more than one option contract for every 100 shares they hold, covered call writers are no longer subject to an infinite upside risk and are not required to provide any margin.

Thus, covered call writing is an investment technique that combines stock ownership with covered call selling. In exchange for the commitment to sell the stock at the strike price at any point up until the option's expiration, the covered call writer receives a premium from the call option buyer. The covered call writer effectively exchanged some of the stock's potential upside for a set return in the form of an option premium in this way.

Although covered call writing entails opportunity risk on the upside (the chance that the stock will increase but they won't fully share in the gain), it also balances downside losses should the stock price fall and generates a fixed return for the period because it raises money for that commitment. For these reasons, covered call writing tactics have been used for decades by institutional investors like pension plans and endowments.

How to Profit From Covered Calls?

In exchange for the right to purchase shares or contracts at a fixed future price, The premium is paid by the call option buyer to the option seller. No matter whether the option is exercised or not, the seller keeps the premium, which is a monetary fee received on the day the option is sold. Therefore, the best scenario for a covered call is one in which the stock rises to the strike price, resulting in a gain from the long stock position, and upon expiration, the sold call is worthless, allowing the call writer to keep the entire premium received from the selling of the call.

Presently, the best-covered call opportunity.

We look for financially sound but significantly undervalued companies to sell Covered Calls using the Best Value Stock list. The best opportunity at the moment is PRGO:

• Based on fundamental analysis, the stock has a 43 percent upside potential.

• An annual dividend yield of 2.56%.

• The stock bottomed out 51 days ago, according to Long Signal Days.

You now understand the fundamentals of trading covered calls. You can see that despite the low risk, each trade has a very high cost, limited rewards, and the potential to cause significant price losses.

Benefits of A Covered Call

Investors may benefit in three different ways from covered calls.

1. The premium from the sale of a covered call may be retained as revenue. 

In order to increase their annual returns by several percentage points of cash income, many investors employ covered calls and have a programme of selling them on a regular basis, sometimes monthly and other times quarterly.

2. Investors might set a selling price for the stock that is higher than the current price by selling covered calls.

For instance, a 40 Call is sold for 0.90 per share and stock is bought for $39.30 a share. In the event that this covered call is assigned, necessitating the sale of the shares, a total of $40.90 will be earned, commissions excluded. Even if the stock price increases to $40.50, the assignment results in a total payment of $40.90. Even if the stock price never rises so high, if the investor is ready to sell stock at this price, the covered call aids in achieving that goal.

3. Obtaining a small amount of downside protection is another reason some investors sell covered calls.

In the scenario mentioned earlier, the premium of $0.90 per share received lowers the stock's breakeven point, which lowers risk. However, keep in mind that the protection - if it can even be called that - is quite limited because the premium from selling a covered call only amounts to a tiny portion of the stock price.

Drawbacks of A Covered Call

The chance cost of the stock being "called" away and preceding any large future gains in it, as well as the danger of losing money if the stock's value declines, are the two main drawbacks of a covered call strategy (which means that instead of using a covered call strategy, the investor would have been better off selling the stock outright.

There are two risks in the covered call approach.

1. The potential risk of going bankrupt if the stock price drops below the breakeven level.

The purchase price of the shares less the option premium collected is the breakeven point. There is a great deal of risk with any stock ownership approach. Even though stock prices can only fall to zero, the amount invested is still lost. Thus covered call investors must be prepared to take on stock market risk.

2. The potential risk of missing out on a significant stock price increase.

The covered call writer is required to sell the stock at the strike price for the duration that the covered call is open. Although the premium offers a small profit margin above the strike price, that margin is nonetheless present. As a result, the covered call writer is limited in their ability to profit from a stock price increase over the strike. Covered call writers frequently believe they "lost a terrific chance" in the case of a significant stock price increase.

Why Sell Covered Calls?

We can trade the Covered Call to protect our position if we want to stay onto a stock for the long term but are concerned about a bearish trend. The PLTR stock can be used as an illustration. Palantir went public for $9 a year ago, surged swiftly to $45, then dropped down to the current $24 price.

Palantir went public at $9 a year ago, surged swiftly to $45, then dropped to its current $24 price. If we had bought 100 PLTR equities at $45, we would currently be in the red. In order to hedge our positions and generate money while we wait for the stock to increase, we can trade covered calls. For a short call with a 0.20 delta at a price of $28, the potential return is $49.

However, our 100 stocks will be called away at a loss of $28 if the stock price increases above $28 before expiration. The call option would expire worthless if the stock price didn't move above $28. The price of our 100 PLTR stocks would therefore be reduced by $49, or to $4,451. Bringing each stock's price down to $44.51. As you sell Covered Calls, the price per share will keep decreasing.

You may have noticed that we must sell a Covered Call at $45 or above to guarantee a profit from the trade. In this manner, we can sell the stocks and still make a profit if the stock price increases beyond the Call strike. However, we see that a $45 short call only has a 0.01 delta, meaning the premium received is a pitiful $3.

With only 0.01 delta on a $45 short call, the premium paid is a pitiful $3. Finding a high delta strike price that gives us a good premium without being breached before expiration is the key to trading covered calls on equities.

When to Sell A Covered Call?

Selling a covered call entails you are compensated in return for forfeiting some potential future gains. Consider purchasing XYZ stock for $50 a share with the expectation that it will grow to $60 in a year. Additionally, you're prepared to give up further upside while reaping a quick profit by selling at $55 within six months. In this situation, selling a covered call on the position can be tempting.

According to the option chain for the stock, the buyer will pay a premium of $4 per share when selling a $55 six-month call option. You may sell that option in exchange for the shares you bought for $50 and anticipate selling for $60 in a year. If the underlying price rises to $55, the covered call's writer is obligated to sell the shares at that price within six months. You get to keep $4 from the premium and $55 from the share sale, totaling $59, or an 18% return over six months.

As opposed to that, if the stock drops to $40, you'll suffer a $10 loss on the initial investment. The $4 premium from the call option sale, which you get to retain, reduces the overall loss from $10 to $6 per share. Many funds use covered call writing as their primary investment approach. (We would provide a small list of these funds, but we cannot advise anyone to use them as they just approximate covered call writing without completely adopting it.)

Writing covered calls is something to think about if you have the time and desire to trade your own money. Not everyone should make this investment decision.

This page is meant to be read by stockholders because CCW begins with stock ownership. The goal is to outline the benefits and drawbacks of including CCW in your financial portfolio. Investors who want to purchase shares of a particular stock to write call options and receive the premium but who do not now hold the stock can use CCW.

As with any other trading decision, you must weigh the pros and cons of the technique before determining whether the risk/reward profile is compatible with your risk tolerance and investment objectives.

3 Scenarios For The Covered Call Writer

Choose a stock from your portfolio that has done well in the past and that suppose the call option is exercised, and you are prepared to sell. Choose a stock that you aren't overly positive about in the long run. In this way, if you have to sell the stock and miss out on future gains, you won't feel too upset about it.

Choose a strike price that makes you comfortable selling the stock. The strike price you select should typically be out-of-the-money. It is so that the stock can appreciate more in value before you have to sell it.

Next, decide when the option contract will expire. Think about 30-45 days in the future as a starting point, but use your discretion. In order to sell the call option at the strike price of your choice, you need to choose a date that offers a reasonable premium.

Some investors believe that 2% of the stock value is an appropriate premium to aim for as a general rule of thumb. Never forget that time is money when considering possibilities. The more valuable an option becomes as you move further into the future. However, it becomes more difficult to foresee what might happen as you move further into the future.

Conversely, watch out for receiving too much time value. There is typically a justification if the premium looks unusually high. Keep an eye out for market news that could impact the stock's price, and always remember that Something is probably false if it seems too good to be true. There are three possible outcomes once a covered call writer sells an option on shares held:

1. The stock price at expiration is equal to or less than the option's strike price:

The option will then expire worthless, freeing the call writer from further liabilities. The call writer, who has the ability to write another call option if they so choose, receives additional money from the premium realized from the sale of the option.

The good news is that the call will expire worthlessly, and you will keep the entire premium you earned for selling it if the stock price is lower when the option expires. The stock's declining value is undoubtedly terrible news.That is a covered call's nature. The stock's ownership introduces risk. The gain from the sale of the call, however, may be able to partially offset the stock's loss.

Don't freak out if the stock drops before the call's expiration date. You're not stuck in your spot. The stock will experience losses, but the call option you sold will also lose value. It is advantageous since you may be able to purchase the callback for less money than you were paid to sell it. You can simply close your position by purchasing the call contract back, then sell the shares if your opinion of the stock has changed

2. If the stock price at expiration is higher than the strike price:

The option will be executed, and the call writer will sell the shares without further action. There isn't much bad news to report in this situation. You keep the entire premium from selling the call option because it would expire worthlessly. Perhaps the underlying stock, which you will still own, has seen some gains. You have no right to criticize that.

3. The call writer repurchases the call option to terminate 

The position is ahead of expiration. Whether the stock has increased or decreased since the initial sale and how much time is left before expiration may result in a gain or loss on the option. The outlook of a covered call writer on the underlying stock or the strategy as a whole may change at any time, and they always have the option to unwind the position and release themselves from any future obligations.

The call option will be assigned, and you will have to sell 100 shares of the underlying stock if the price of the stock at expiration is higher than the strike price. You could think of criticizing yourself for missing out on any more gains if the stock soars after you sell the shares, but don't. You intentionally chose to sell the stock at the strike price, and by doing so, you maximized the strategy's potential for profit. Give yourself a high five. Alternatively, have someone else pat your back if you're not particularly flexible. You did a good job.

How To Sell Covered Calls?

The procedure for selling covered calls presumes that the investor has the required $2,000 in equity as well as a brokerage account with options approvals.

1. The stockholder purchases (or owns) 100 shares.

2. After choosing a call option with the desired strike price and expiration date, the investor sells the call option contract. (The investor's position is referred to as "short" rather than "long" because they are opening an option position by selling one they already have.)

3. The option seller is free to select any expiration date or strike price that best suits their strategy and forecast for the stock. Selling calls with higher strike prices typically yields a lower option premium but permits the stock to rise more before reaching the strike price and running the risk of being called away. On the other side, selling calls with lower strike prices generates higher profits but raises the chance of losing the stock to an exercise. The amount of potential upward gain that investors are ready to give up in exchange for a set return throughout the time must be considered.

4. The option writer must also choose an expiration date for the option. A call writer will receive more premium as the expiration date approaches, but they will have more time to sell the shares at the strike price. Additionally, there is no linear relationship between time value and option premiums. Consequently, extending the time horizon by two results in a yield that is less than two times the option premium.

Potential Advantages of Covered Call Writing

Income: The investor receives the option premium when they sell one call option for every 100 shares of stock they own. Whatever happens in the future, you can retain that money.

Safety: Any premium received provides the stockholder with limited loss protection in the event the stock price drops, even if it might not be much money (although it occasionally is). For instance, if you purchase a stock for $50 per share and sell a call option that pays a $2 premium per share, you will be $2 per share better off than the stockholder who chose against writing covered calls if the stock price falls. You can approach it from two equal angles: The breakeven price decreases from $50 to $48 as a result of the $2 per share cost base reduction.

The likelihood of profiting rises: If you own shares at $48 per share, you profit any time the stock is above $48 when expiration occurs. This characteristic is frequently disregarded. If you own stock at $50 per share, you make money whenever it rises above $50. As a result, whenever the price is above $48 but below $50, the stockholder with the smaller cost basis (i.e., the one who writes covered calls) makes money more frequently.

Potential Disadvantages of Covered Call Writing

Capital gains: Your gains are constrained when you write a covered call. The option's strike price is set as your maximum selling price. Yes, you get to increase the sale price by the premium received, but if the stock appreciates much, the covered call writer forfeits the chance to make a substantial profit.

Flexibility: You are unable to sell your shares while you are short the call option (that is, you sold the call, but it has neither expired nor been covered). If you did this, you would be "naked short" the call option. That won't be permitted by your broker (unless you are a really seasoned trader or investor). As a result, even though it is not a big deal, you must cover the call option concurrently with or before selling the shares.

The dividend: Before it expires, the call owner has the opportunity to exercise the call. They take your shares and pay the strike price per share. You sell your shares if the option owner chooses to "exercise for the dividend" and if this happens before the ex-dividend date. In that case, you wouldn't be eligible to receive the dividend because you didn't hold any shares on the ex-dividend day. Although it's not necessarily bad, it's vital to be prepared for it.

3 Reasons Why Not Sell Covered Calls

Although the Covered Call plays a significant role in the Wheel Strategy, we prefer not to trade Covered Calls for the following three reasons:

1. A covered call has extremely low returns and a high capital need.

2. Low option premiums are typically found in good dividend stocks.

3. Covered Calls may miss out on growth stock bullish trends that emerge suddenly.

1. A Covered Call Has Very Low Returns and Needs Too Much Capital

We can observe that the Covered Call necessitates the acquisition of 100 stocks, costing around $2,400 in capital. However, a Bull Put Spread on an ATM simply needs $51 in Buying Power.

The Covered Call has a far larger capital requirement than a short Bull Put Spread because it calls for purchasing 100 stocks. Although both strategies expire in 30 days, the ATM Bull Put Spread has a return of 96% compared to a Covered Call strategy's maximum return of 16%. The annualized return on covered calls is then 192 percent, compared to the annual return on ATM put spread of 1,152 percent. Therefore, employing so much money to trade covered calls for a meager return has an opportunity cost. Instead, we advise trading Poor Man's Covered Calls.

2. Good Dividend Stocks Usually Have Poor Option Premiums

Since dividend stocks or ETFs have lower IV and hence receive a lesser premium from the Call options, they make poor candidates for trading covered calls. The greatest profit from trading a Covered Call for SPY at 0.20 delta, for instance, would be 2.9 percent due to the very low strike price. The greatest gain from trading a Covered Call for SPY at 0.20 delta is merely 2.9 percent.

A better approach is to invest in high dividend-yielding equities and hold them for a steady stream of dividend income for early retirement.

3. Covered Calls May Miss Out on Growth Stocks' Sudden Bullish Trends

A 0.20 delta Covered Call offers a maximum return of 11% if we try selling them on a high IV growth stock like TSLA.

The maximum return on a 0.20 delta TSLA covered call is 11%. Additionally, we have a potential upside of almost $86 at the strike price. Which initially seemed positive, but then we see that TSLA would encounter bullish trends that saw a $100 increase over 30 days. In fact, there were three instances of these price spikes last year. We would have missed the significant returns if we had traded Covered Calls for TSLA throughout the previous year.

Three times in the past year, the TSLA stock price saw significant increases of at least $100. Trading covered calls would have prevented the substantial profits. Detecting bottom-out signs and using Bull Put Spreads are better strategies for trading growth equities.

FAQs on Writing Covered Calls:

Q1. If the price of the stock drops, should you still own it?

The stock is the most crucial component of covered calls. Losses below the breakeven point will practically dollar for dollar increase if the stock price drops significantly. Therefore, it's crucial to concentrate on "high quality" stocks that you're willing to hold onto throughout the market's inevitable ups and downs.

Q2 Should I sell the stock if it increases in value?

• You must consider this duty because covered calls entail the need to sell stock at the call's strike price.

• You really need to consider carefully whether or not you want to sell covered calls on a stock that you've held for a while and want to keep for a long time.

• In addition, selling it could result in a sizable tax obligation if you have a sizeable unrealized profit in that stock. It could be prudent to avoid selling covered calls on such stock.

• In general, investors who are not emotionally attached to the underlying stock are best suited for covered calls. On average, selling recently bought stock is more accessible to decide rationally than holding it for an extended period.

Q3. Are the static and if-called rates of return enough for you?

• Calls that are in the money typically have higher static returns and lower if-called returns.

• In contrast, out-of-the-money calls typically give larger if-called returns and smaller static returns.

Which one is best for you? There is no definite "correct" response to this query. The choice is a personal one that each investor must make for themselves.

Q4. If you Sell the Underlying Stock Before the Covered Call Expires, Are You Taking a Risk?

Yes, there is a significant risk involved since if the underlying stock is sold before the covered call expires, the call will become "naked" as it is no longer owned. Similar to a short sale, this may theoretically result in limitless losses.

Q5. Should you write a covered call on it if you intend to hold a core stock position with significant unrealized gains for the long term?

Given that selling the shares could result in substantial tax liability, it might not be a good idea to do so. Additionally, you might not be very pleased if the stock is called away if it is a core position that you want to retain for the long term.

The Bottom Line

Use covered calls to increase the profit potential of stock or contract ownership, lower cost basis, or generate income from shares or futures contracts. Writing covered calls has benefits and drawbacks, just like any other technique. Covered calls can be a terrific strategy to lower your average cost or produce money if used with the correct stock.

A covered call, commonly referred to as a "buy-write," is a two-step technique in which shares of stock are bought, and calls are sold.

Investors may gain income in neutral to positive markets, a selling price above the current stock price in rising markets, and some downside protection by using covered calls. Investors should also be (3) OK with the anticipated static and if-called returns and be (1) willing to own the underlying shares and (2) willing to sell the stock at the effective price. Cover covered calls lose money if the stock price falls below the breakeven level. If the stock price increases above the covered call's the effective selling price, there is also an opportunity risk.

A popular trading tactic known as "covered call writing" entails both owning stock and selling call options on that asset. The technique offers special advantages such as generating income, reducing the price volatility of stock holdings, and hedging downside risks. It can be applied in various ways to meet an investor's holdings, risk tolerance, and objectives. Covered call writers give up part of the upward potential in the stock or stocks on which they have written call options in exchange for agreeing to sell their shares at a price stated by the option.

An option exercise could result in covered call writers being forced to deliver their shares to a third party. The variety of listed options available on various equities offers many opportunities to profit from the approach for investors willing to understand it and incorporate covered call writing into their portfolios.