The Basics of Selling Covered Calls
When you’re learning to trade in the stock market, you have a number of options available to you depending on what your goals are. One option is the covered call, which is an enticing strategy for new and veteran investors. Learn more about covered calls, including what the advantages and risks are, how to make money from them, and what your profit and loss potentials are.
What Is a Covered Call?
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A covered call is where you essentially give someone else the right to purchase the security you own for cash as long as the deal happens before a predetermined expiration date and for a predetermined price, called the strike price. A covered call is one of the most popular trading options for investors because it’s a strategy with reduced risk as long as you make an educated trade.
One covered call option contract is represented by 100 shares, so you’ll have to own at least 100 shares to be able to use this strategy. You don’t have to sell all of your stocks during a covered call either. For example, if you own 500 stocks, but only want to write three covered calls, you would retain 200 shares of stock for yourself to keep or write a call on at a future date. When you sell or “write” this call, you immediately keep the premium you earn, then sell the stocks at the strike price to your buyer.
When you sell your covered calls, you typically get paid extra money to sell that stock at a certain price. This is beneficial for buyers because you’ll still be obligated to sell at market price even if the stock becomes highly valued. Investors use covered calls to increase their income and mitigate risk within their portfolio when they believe that stock prices are not likely to rise much in the short-term.
Frequently Used Terms of a Covered Call
It’s important to become familiar with vital terms related to covered calls so you know how you want to move forward with your investment. Here are a few to know:
- Premium: This is the amount of money a buyer must pay you per share for the benefit of getting in at a stock’s market price.
- Close-out: A close-out is when you buy back your covered calls, either at a loss or a profit, and keep your stock.
- Unwind: This option is when you want to buy back your covered calls and also sell your stock.
- Rollout: A rollout is when you buy back your covered calls and sell them again at a later month for the same strike price.
- Rollout and up: This option is when you buy back your covered calls and sell them again at a later month for a higher strike price.
- Rollout and down: A rollout and down is when you buy back your covered calls and sell them again at a later month for a lower strike price.
There are two other calls you can make as part of a covered call strategy, which include:
Out-of-the-Money Call: Also called an OTM call, this option is when the call has a strike price that is higher than the current stock price.
For example, if you buy 100 shares of stock for $25 per share and you sell a call option with a $27 strike price, you can charge a premium of $1 per share, or $100 in total. The total cost per share would then be $26 because you immediately receive the premium charge of $1 per share. If the stock falls to $25 per share, the option will expire because the strike price is not met, yet you get to keep the $100 premium. If the stock rises above the strike price of $27 at the expiration time, you can sell your shares for $27 and also keep the option premium of $100.
In-the-Money Call: Also called an ITM option, this strategy has a strike price that is less than the current stock price. When you decide to sell an ITM option, you can collect a higher premium.
How to Write Your Covered Call
To write a covered call, you’ll first have to own stocks. When you own the security, this option is then called a covered call. When you don’t own the security that you’re selling, it’s called a naked call.
Once you own some stocks, follow these steps to write your covered call:
- Take a look at your portfolio. Before exercising any options strategy, it’s important to have a handle on how your securities are doing so you can make an informed decision. See which stocks are performing well, which aren’t doing so great, and which you are willing to sell to an interested buyer. Avoid offering up a stock that you feel will increase significantly in price because then you may be missing out on future gains.
- Pick a strike price. The strike price is the amount you’re willing to sell your securities for. What your strike price is will determine how much of profit you’ll make.
- Choose an expiration date. The expiration date is completely up to you, but consider what it will take to close the deal at your strike price so the buyer benefits and you get your maximum potential profit. Many investors start at 30 to 45 days from the present day. The more in the future you set your expiration date, the higher your option’s worth should go, but it can also mean a more unpredictable stock price.
How to Make Money With Covered Calls
The best way to make money with covered calls is through the premium charge you pass on to the buyer of your stocks.
The buyer will pay you a premium amount per share to have the right to buy those shares at your strike price before the value goes any higher. This premium is paid in cash to you by the buyer when the option is sold to them and it’s a charge you get to keep as the seller, even if the option doesn’t come to fruition.
Advantages and Risks of Covered Calls
As always, it’s important to be aware of any advantages and risks when engaging in trades and investment opportunities. Here are the benefits and potential downfalls of covered calls:
Advantages of Covered Calls
The advantages of covered calls are:
- You can mitigate your risk of a stock dropping in value by selling before that happens.
- You can get cash in your pocket from charging a premium to your buyer in exchange for future profit on the shares beyond the strike price.
- You have some flexibility, which allows you to protect your securities and your money and control what happens with your stock without having to invest a large dollar amount.
With the right stock, strike price, and expiration date, plus the stock moving in the direction and at the pace you’re hoping for, you have a great possibility of generating an income from producing covered calls.
Risks of Covered Calls
The great thing about covered calls is there aren’t many risks, which is why it’s an attractive option for sellers. The greatest risk of covered calls is that you may have a stock that drops in price and therefore, doesn’t make you as much of a profit.
Maximum Loss on a Covered Call
You may be wondering how much you could possibly lose on a covered call. After all, you probably don’t want to get into a situation where your maximum loss is beyond what you’re comfortable with. With covered calls, the most you’ll lose on the deal is your stock purchase price minus the premium you receive for writing the call.
For example, if you invested $1,000 in shares and received a premium payment from a buyer of $400, only for your stock price to drop in value to zero dollars, you would lose your entire $1,000 investment but retain the $400 premium price. Therefore, your total loss would be $600.
Maximum Profit on a Covered Call
K nowing your maximum profit on any options strategy can help you decide if it’s a path you want to go down, depending on how much your potential gain is, what your risk tolerance is, and how much strategy you want to employ.
The maximum profit you can earn on a covered call option is how much you retain once you have your strike price, factor in how much you purchased the stock at, and consider the option premium you’ve received from your buyer. For example, you buy stock at $50 per share and receive a $1 option premium for selling your stock at the strike price of $52. There is a difference of $2 between the price you purchased the share at and the price you sell it at, plus you’ve received a $1 premium on each option. That means your maximum profit is $3.
Whether you’re a new or seasoned investor, consider covered calls for how easily you can make a profit. Especially as you’re starting to generate income with stocks, the covered call provides a lot of security throughout the process.