Selling Covered Calls

Selling covered calls is probably the most common (and one of the most conservative) option trading strategies;  however, that doesn’t mean it’s a free lunch. Selling covered calls refers to selling a call option on a stock you already own (i.e. your short position is covered). You are then obligated to sell your shares to the buyer of your call option for a predetermined price, called the strike price, if and when the buyer chooses to exercise his option on your shares.  If the price of the underlying stock moves above the strike price before expiration, you are still obligated to sell at the lower strike price and therefore miss out on any additional upside.  If, however, the price stays below the strike price you get to keep both the stock and the option premium.  Thus, when selling covered calls you generally want the stock’s price to stay below the strike price so you can keep the premium and still participate in the stock’s future upside potential.

Selling Covered Calls

The covered call strategy is made up of two parts. First, you must already own the stock in question. The stock does not have to be in 100 share blocks; however, will need to own at least 100 shares of the stock (each option represents 100 shares). The second part of the strategy is to then write or sell one call option for every multiple of 100 shares you own and wish to “gamble” with, so to speak . For example, if you wish to option 100 shares you will only need to sell one option contract, 200 shares is covered by 2 call contracts, 376 shares is (mostly) covered by 3 call contracts, and so on.

It’s important to remember that when selling covered calls, your risks will be a little different than someone who owns the stock unencumbered. While you will get to keep a premium you earn when the option is sold, if the stock price then rises higher than the strike price, the total amount you can earn is capped. If the stock falls lower, you can’t just simply sell the stock since you are still obligated to sell your shares to the person who bought the option contract from you.  Instead, you’ll need to buy an equivalent call option to close out your position first.

There are several reasons a trader can, and should, used a covered call strategy. The most obvious reason is because a trader is looking to generate income on stocks that are already a part of a portfolio. Another reason to use this strategy is if you see the appeal in an option’s premium time decay, but do are not comfortable with assuming the potentially unlimited risk you would incur by writing naked options (a naked option is simply an uncovered option).

A potentially good use of the covered call strategy is to work with a non-volatile, high-yielding dividend stock you currently hold and wish to hold for a long time to come (for example, dividend or tax-relates purposes). Since the stock in question isn’t particularly volatile, there’s a good chance the stock will not be called away from you.  And even if it does, you probably won’t need to pony up too much extra in order to buy it back.  The premium income generated from this strategy can be attractive, however, it’s important to note premium income is generally taxed at your regular income tax rate.