Looking for income? Covered calls let you generate income on investments you own (stocks or ETFs, exchange-traded funds) with the risk that you might be obligated to sell your shares at the strike price. Of course, it's important to learn the ins and outs of this options strategy before you put it to use.
Here, we cover (pun intended!) what you should know about covered calls.
What is a covered call?
A covered call has 2 components: owning an investment (typically a stock—which we will use as the example going forward) and selling a call option on that same investment. The shares that are owned cover the obligation created by selling to open the options contract. This way, the shares are ready to be delivered to the option buyer (to cover the transaction) if the contract is exercised.
Let's slow down to talk about each component of this strategy. The stock can be owned well in advance (e.g., a long-term stock position in an IRA account) or it can be purchased while implementing a covered call. When you execute the trade, you can choose to do a "buy write," where you simultaneously purchase the stock and sell the call, or you can "over write" to sell the call on a stock you already own.
A call option is a contract that controls a specified number of shares that can be exercised at a specified price (the strike price) before a specified date (the expiration date). If the contract is exercised by the buyer, the options seller is required to sell the underlying investment to the options buyer at the strike price, regardless of the current price.
So, why is this an income-generating strategy? Because the options seller receives money—known as the premium in options lingo—for selling the call. The outlook of the seller is that the underlying stock price will remain mostly unchanged or rise a relatively small amount. If that outlook happens, the options seller gets to keep the premium and maintain ownership of the shares.
How does a covered call work?
If the actual price for the stock covered by the options contract stays below the strike price and the option buyer does not exercise the contract, you keep the stock and the premium you were paid. Remember that a covered call requires being okay with selling the underlying stock if the contract is exercised. You should also be sure you are okay with keeping the stock after the contract expires.
Alternatively, if the actual price of the underlying stock or ETF rises above the strike price before expiration, on the other side of the trade the option buyer has the right to exercise the contract and buy the investment shares from you at the strike price. Remember that an option buyer and seller are on opposite sides of the same contract. This is one of the risks of executing a covered call—you get income for selling the call in exchange for losing out on upside potential of the underlying stock you own during the life of the contract. That's why the outlook for a covered call writer is for the stock to remain mostly the same or rise just a little from the current price.
An example of a covered call in action
Let's use a hypothetical example to illustrate what we've covered. Suppose it is January 15 and you own 400 shares of a stock (XYZ), which are currently worth $39.30 per share. Further, suppose that you don't think the stock is going to increase that much or at all over the short term, let's say over the next couple months.
If you look in the options chain (where options contract are listed for purchase), you might find that 1 call option covering 100 shares of XYZ stock with a strike price of $40 is selling for $0.90 per contract. Here, the buyer has the right to exercise the contract to buy the XYZ shares at $40 a share before the contract expires. On January 1, you sell 1 XYZ contract and receive $90. Remember that each contract covers 100 shares, so the calculation here is the number of contracts times (1), times number of shares covered by each contract (100), times the premium ($0.90 per contract). In real life, sellers might sell multiple contracts covering more shares to generate higher income.
Now, in the next 60-odd days there can be several outcomes. The price could stay below the strike price during the life of the entire contract. In this case, you keep just the $90 premium if the buyer does not exercise the option: 1 contract x 100 shares per contract x $.90 per contract. Note here that you may still experience a loss: You still own the stock, and a decrease in the price lowers the value of the stock you still own. Of course, the premium received for selling the call will help offset some of that unrealized loss. As long as the stock price stays above $38.20 when the contract expires, you break even. (Breakeven is calculated as the share purchase price minus the premium received from selling call option. So $39.30 - $.90 = $38.40).
It's also possible that the underlying stock price is volatile, rising above and falling below $40 during the life of the contract. At any point above $40, the buyer may choose to exercise the strike price. If XYZ's share price rises above the strike price of the call option before expiration, the option buyer could choose to exercise their right to buy shares from the call option seller, effectively calling away the shares, during the life of the contact. Or it may be automatically exercised if it is in the money at expiration. If XYZ reaches $40 and is exercised, that means you make a profit of $1.60 per share. This is calculated as a gain on the stock of $0.70 ($40 minus $39.30, which was the original price), plus the $0.90 premium per share. Maximum profit is realized if the market price rises to the strike price.
But seller beware: This $1.60 per share is the maximum you will make from this position. If XYZ's price continues to rise before the contract expires (let's say it doubles to $80, for example), you still only will make $1.60 per share.
Advantages of covered calls
- You earn income immediately. Because you receive a premium when you sell the call, you get income without having to sell your stock.
- You potentially lock in a higher price for your investment. If you want to sell your investment but are just waiting for its price to rise to a certain threshold, a covered call ensures you sell if your target price is reached. This may sound similar to a limit order, a type of instruction you can give your brokerage that requires an asset to be sold if a certain price is reached. With a limit order, however, you don't receive a premium.
- You get a little downside protection. By holding the securities until a certain price is reached, it's possible your security's price could drop in value while you wait. The premium you receive from the covered call can help offset some of those potentially realized losses, though certainly not all, as you saw in the example.
Disadvantages of covered calls
While there are some benefits, a covered call strategy also has risks to be aware of:
- Losing out on a possible large share price increase. If the price of the stock in the covered call rises, you may miss out on some—or the bulk—of its gains. The potential gains you could miss out on are hypothetically limitless, meaning a covered call probably isn't the right strategy for investments you're extremely optimistic about.
- Potential tax liability. If you end up having to sell your stock or other security, you may owe taxes on your profit if you're investing in a taxable brokerage account. If that investment has large unrealized gains, meaning the price you paid to buy is much less than the strike price you sold at, you could wind up with a taxable event.
- Assignment risk. If a contract is "in the money" (i.e., the price of the underlying is higher than the strike price), an options contract can be assigned at any time before the expiration. This could cause you to be forced to sell your underlying position. Remember that with a covered call, you must be comfortable with selling your position when entering the trade.
How to sell covered calls
Options contracts have unique characteristics and risks and should be carefully considered within the context of your overall investing plan. If you'd like to sell covered calls, here's a guide to consider.
1. Open a brokerage account with options trading
To be able to trade options, you first need a brokerage account. Look for an account with low fees, as well as the research, investing, and trading capabilities that align with your strategy before opening the account. Don't forget to fund your account once it's open.
2. Apply to trade options
Depending on your financial institution, you may need permission to trade options. At Fidelity, you first have to complete an options application before you can execute strategies like selling covered calls.
3. Research investment options and execute trades
Your brokerage may have resources to help you research and plan an options strategy. For instance, Fidelity offers the Option Strategy Builder to help you build and place an options trade. Once you have a stock or ETF in mind, log into your brokerage account to get started.
The options chain shows you contracts at different strike prices and for different durations. Once you've found a combination that you like, you can start selling covered calls right from the options chain.