When an investor sells call options against shares that they already own or have purchased specifically for this transaction, it is known as a covered call. Selling call options as part of a covered call strategy is a type of investment strategy. It's the ability to purchase stock against stock that you currently hold or recently purchased in order to produce additional money from those shares. You own enough shares to pay the transaction as needed by the option you've sold; thus, the option you've sold is "covered." Covered call methods can help investors make money, but they can also limit the amount of money they can make from stock price increases. Find out how a covered call strategy works and if it's right for you.
A Covered Call Strategy is defined as:
When an investor sells call options against stock they already own or have purchased specifically for this transaction, it is referred to as a covered call. You grant the call option buyer the right to buy the underlying shares at a specific price and time by selling the call option. Because you already hold the stock that will be sold to the buyer of the call option when it is exercised, this technique is "covered." Writing covered calls is a different name for the same thing.Two steps comprise a covered call strategy
To begin, you must acquire stock shares. You are free to choose the stock in whatever way you choose. It's crucial to conduct your homework before making any investment. Stocks with stable pricing and low volatility operate well with covered call strategies. Second, you sell call options on the stock you just bought. The buyer of a call option has the choice to purchase shares at a certain price, but not the duty. The buyer must pay you a premium when you sell the option, which you keep as profit. Typically, 100 shares are involved in each option deal. Note that a variety of criteria determines the buyer's premium. The link between the stock's share price and strike price, the option's expiration date, and the volatility of the stock's share price are all taken into account.What Is a Covered Call Strategy and How Does It Work?
A popular options strategy is a covered call. When compared to other options, it's frequently seen as low-risk. It might assist you in generating revenue from your investment portfolio. Many brokerages will let you sell covered calls even if you don't have permission to trade other options. Covered calls are considered low-risk since the amount of money you can lose is limited. You can be exposed to theoretically unlimited risk with some other options contracts. Important: The worst-case situation with a covered call is that you must sell shares you hold or that the shares you own lose all of their value minus the premium you got. The potential loss in both scenarios is limited. "Covered calls can be a tremendous source of revenue," Henry Gorecki, CFP, told The Balance. "However, you should always be prepared to lose the underlying stock." "Think twice before writing calls on a great, expanding company's stock that you might want to own for long-term appreciation." You're not only preventing yourself from losing money when you use a covered call strategy. You're also limiting how much money you can make from a rise in the stock's price. In exchange, you will earn money in the form of the option buyer's premium.A Covered Call Strategy Example
Jane invests $5,000 in firm XYZ by purchasing 100 shares at $50 apiece. She believes the stock will improve in value, so she sells Joe one option contract with a strike price of $55. Joe gets charged $20 extra for this call choice. Joe is unlikely to execute the option if the stock price does not rise over $55, so it will expire. Jane gets to keep her shares and keep the $20 Joe paid her if this happens. Her total profit or loss will be $20, plus or minus any price fluctuations in XYZ since she purchased it for $50 per share. Jane's ideal situation is for the stock to climb to exactly $55 before the option expires, but Joe does not exercise his option. If this occurs, she will keep the $20 she received from Joe as well as her shares, which are now valued at $5,500. Her total gain is $520, including the $20 she received from Joe. The worst-case scenario is that XYZ's stock loses all value. Jane will lose her $5,000 initial investment if this occurs. She does, however, get to retain the $20 Joe gave her. That would be a tremendous loss for her. Tip: If the option buyer does not exercise the call option before it expires, you can keep selling covered calls against the same shares and collect extra premium payments. If XYZ rises to $60 per share, Joe can exercise the option before it expires. Jane will receive $55 per share. Jane will keep the $20 premium, and Joe will pay her $5,500 for her 100 shares. This would bring her total profit to $5,520. She would, however, miss out on possible earnings because her shares could have been sold for $60 each. Instead of $5,500, she might have made $6,000. However, the call she sold to Joe forces her to accept only $55 per share plus a $20 premium.Covered Calls vs. Stock Ownership
When you purchase a stock, you acknowledge that the stock may lose some or all of its value. As the stock price grows, so does the value of your investment. While owning stock is simple, selling a covered call might be more beneficial in some instances. The table below explains how stock price movements affect your investment when you hold a stock instead of selling a covered call. Change in Stock Price Result If You Own Just Stock Result From Selling Covered Call More Profitable Option Increase the price of the covered call over the strike price. Profit proportional to the price growth of the stock You profit up to the option's strike price plus the premium, which is less than the investment's value based on the current share price. You also give up any future gains from rising stock prices. Owning just the stock Increased, but still below the covered call's strike price Profit proportional to the price growth of the stock Profit is equivalent to the increase in the stock's price plus the premium, both of which are greater than the investment's worth based on the current share price. Selling the covered call. No change None The premium received Selling the covered call Decrease Loss proportional to the stock's price decline Loss is equivalent to the difference between the stock's current price and the premium paid. Selling the covered call. Taxes and Covered Calls When it comes to making money on covered calls, one thing to keep in mind is taxes. This may be a severe disadvantage for some. "On covered calls, net gains and losses are short-term capital gains and losses," Gorecki explained. "Short-term capital gains are treated like regular income," which means you could pay more in taxes than if you had made long-term capital gains. But it's not as straightforward as that. When an option is exercised, the options industry clearing house, Options Clearing Corporation (OCC), sends the exercise notice to brokerage companies with a client account with an equivalent option position at random. This is referred to as "assignment." Once that happens, the "strike price plus the premium paid, as well as the cost basis and holding time of the underlying stock" will determine short- and long-term capital gains or losses.Pros and Cons of Covered Calls
Pros
- Earn more money by selling shares you already hold.
- Assist you in selecting your stock's target selling price.
- In comparison to other riskier options trading strategies, losses are limited.
Cons
- Limit the amount of money you can make if stock prices rise in the future.
- You must hold the stock until your options expire.
- Capital gains taxes apply to net gains.
Explained Benefits
Make extra money with the stocks you already own: The buyer pays you a premium when you sell a covered call. This method can help you make money each time you sell a call if you want to make money from your portfolio. Assist you in determining a target selling price for the stock you own: You can use covered calls to target a selling price that is higher than the current market price. Unlike other riskier options trading strategies, losses are limited: Even in the worst-case scenario, if the stock collapses to zero and the shares become worthless, the loss is limited, unlike other options methods, which might expose investors to permanent losses.Explaining the Drawbacks
Limit the amount of money you could make if stock prices go up in the future: The premium you receive plus the difference between the strike price and the current price per share is the maximum profit you may make when selling a covered call. You'll still have to sell the shares at the strike price if that share price rises over the strike price. Until your options expire, you must continue to own the stock: You may need to liquidate some of your investments if your plans alter. To keep a call covered, you must own the stock until the option expires, which may require you to retain the stock for longer than you want. Capital gains taxes apply to net gains: Depending on a variety of conditions, you may be required to pay short-term or long-term capital gains taxes.Individual Investors: What Does It Mean?
Selling covered calls is a common practice used by long-term investors looking to supplement their income. Picking the right company to sell the option on is crucial to covered call strategy success. Then, choose the right strike price. So long as the stock price remains below the contract's strike price, simple covered calls work well. It also limits potential losses because the premium received from selling the option cannot be lost. The strategy's main risk is missing out on gains if the value of your investments rises too quickly. Covered calls are an excellent place to start if you're ready to get your feet wet in options trading. Selling a covered call may be more profitable than owning the stock in some circumstances. On the other hand, Options trading is difficult and not suitable for everyone. Before making a decision, consider your risk tolerance.Main Points
- Covered calls are a way to supplement your stock portfolio with additional revenue.
- Because you own the shares in the option, covered calls are low-risk investments.
- You forfeit potential gains beyond the call contract's strike price in the worst-case situation.
- Long-term investors with shares in reliable corporations should consider covered calls.
- Capital gains tax may apply to the net gains on covered calls.
