What is a covered call?
A “covered call” is an income-producing strategy where you sell, or “write”, call options against shares of stock you already own. Typically, you’ll sell one contract for every 100 shares of stock. In exchange for selling the call options, you collect an option premium. But that premium comes with an obligation. If the call option you sold is exercised by the buyer, you may be obligated to deliver your shares of the underlying stock.
Fortunately, you already own the underlying stock, so your potential obligation is “covered” – hence this strategy’s name, “covered call” writing.
Don’t forget, like all strategies, covered calls are subject to transaction costs. This strategy involves two trades and therefore has two commissions: one to purchase the stock and one to sell the call. At TradeKing, the commission for this trade is $4.95 to buy the stock, plus $4.95 plus 65 cents per contract to sell the call.
Why write covered calls?
When you sell covered calls, you’re usually hoping to keep your shares of the underlying stock while generating extra income via the option premium. You’ll want the stock price to remain below your strike price, so the option buyer won’t be motivated to exercise the option and grab your shares away from you. That way, the options will expire worthless, you’ll keep the entire option premium at expiration and you’ll also keep your shares of the underlying stock.
If your stock’s price is neutral or dropping a bit, but you still want to hold onto the shares longer-term, writing covered calls can be a good way to earn extra income on your long position. But remember, you’re also a stockholder, so you’ll most likely want the value of your shares to increase – just not enough to hit your covered call’s strike price. Then you won’t just keep the premium from the options sale, you’ll also benefit from the shares’ rise in value. You’re really loving life if that happens.
An example of a covered call in action
Imagine you already own 100 shares of XYZ. You bought them for $25 each, plus the commission of $4.95, and now XYZ is trading at $50 - but it doesn’t seem likely to rise much in the short-term. Still, you’re long-term bullish on XYZ and want to see if you can make a little extra cash while waiting for a bigger bump in the stock.
In January, you sell one covered call contract on XYZ. Let’s say the option you’ve sold has March expiration and a strike price of 55. The premium you collect is $2.50 per option, or $250 ($2.50 x 100 shares = $250) less commissions of $5.60.
If XYZ stays around $50 until March expiration, the call would be out-of-the-money. That means buying the stock for the strike price ($55) is more expensive than buying the stock in the open market ($50). So the option buyer would most likely not exercise the call and the option would expire worthless. You pocket the $250 premium AND keep your 100 shares of XYZ. Keep in mind, as long as the options you sell don’t get exercised, you can repeat this maneuver from month to month, selling additional covered calls against the same shares of stock.
What happens if the stock shoots through the roof?
What happens if you write a covered call - and then your underlying stock shoots skyward, exceeding the option’s strike price? In that case, the option buyer has reason to exercise his or her call option because buying the stock for the strike price is cheaper than buying the stock in the open market. This is called being in-the-money. In that scenario your shares will mostly likely be called away from you. You might be sad to part with your stock and miss out on some of those gains - but the scenario holds some benefits for you.
For example, let’s imagine XYZ shoots from $50 to $65, and you’ve sold a March 55 covered call. In this scenario, the option buyer is extremely likely to exercise his or her right to buy the underlying shares. After all, the call option allows the buyer to purchase XYZ at only $55 when everyone else has to pay $65 - a difference of $10 per share.
As the covered call writer, you haven’t made out too badly either. When you sold the call, the stock was $50, and now you’re cashing in at $55 - that’s a profit of 10% on the stock alone. Plus you get to keep the $2.50 premium you collected when selling the covered call in the first place - an additional 5%. Not too shabby. Anytime you enter into a covered call position, you must be willing to part with the stock at the strike price. So pick a strike price that will account for enough gains that you won’t feel sorry for yourself if your stock gets called away.
What is "assignment"?
As indicated earlier, if you sell a covered call, you’re accepting an obligation in exchange for the option premium you collect. Your underlying shares of stock might be "called" away from you if the option buyer chooses to exercise. We say "might" here because it’s not guaranteed that you’ll be asked to honor this obligation. It depends on whether you get assigned. Here’s how the assignment process works.
"Assignment" happens via a random lottery system run by the Options Clearing Corporation (OCC). When the OCC receives an exercise notice, it’s assigned randomly to a member clearing firm. In turn, your brokerage firm randomly assigns exercise notices to short options positions on their books. So it’s possible you’ll be assigned through this process.
Of course, it’s also possible you’ll skip out scot-free. But if the call option you’ve sold is more than a few cents in-the-money at the expiration date, the chance of escaping assignment is highly unlikely. In addition, even though exercise usually depends upon whether the option is in- or out-of-the-money, an option buyer can choose to exercise his or her option at any time until expiration, for any reason, whether it makes sense or not. As you’re probably aware, human beings don’t always behave in a rational manner.
What are the risks in covered call writing?
Although covered call writing is generally considered a fairly conservative option strategy, there are risks. Remember, as a covered call writer you’re wearing two hats: You’re a call seller and you’re also a stockholder.
Downside risk as a stockholder. If the value of your underlying shares falls significantly, the loss from holding the stock will likely outweigh the gain from the option premium received.
Limited upside as a stockholder. Before selling a covered call, as a stockholder you have unlimited potential upside from owning the stock. When you start writing covered calls, your potential gain from owning the stock is limited to the gain you may realize if the share price reaches the strike price of the option. At some point after this occurs, the shares will likely be "called away" and you will sell the shares for the strike price.
How You Can Use Covered Calls Successfully
Tip 1: Keep volatility (likelihood of stock price movement) in mind.
Writing covered calls works best on stocks with options that are exhibiting medium implied volatility. This means you want to use a stock that has the ability to move, but in a somewhat predictable way. If implied volatility is too low, the option premium you collect will also likely be low. If implied volatility is high, the premiums will also be higher, but there is a trade-off.
The higher the implied volatility, the greater the likelihood for the stock to move significantly in either direction. This could mean you have a higher chance of having your stock called away if the price increases, or of taking a loss if the stock drops sharply. Remember: If the price rises enough that the call buyer exercises the option and calls your stock position away from you, you’ll no longer be a stockholder – precluding you from participating in future gains in the stock beyond the strike price.
In other words, medium volatility should provide enough premium to make the trade worthwhile, while reducing the amount of unpredictability found with high-volatility stocks. Only you can decide what kind of option premium will make this strategy worth executing.
One final thought for Tip 1: implied volatility can only be determined using an options pricing model. While this information can be helpful in your decision making process, it’s still hypothetical. Again, implied volatility tends to indicate the likelihood of a stock fluctuating. But bear in mind, this may not turn out to be the case in the real world.
Tip 2: Don’t panic if you’re assigned.
If you’re called upon to deliver stock, it can come as a surprise. Some covered call writers worry about losing a long-held stock position this way. But you have more choices in this situation than you may realize. Let’s say you've bought 100 shares of XYZ per year over the last five years, and with each new purchase,the price was higher than the previous one. Then you write one covered call against your holdings. If you are assigned, you can choose the specific lot of shares you wish to deliver from all shares of XYZ that you own. The best course of action may be to deliver the most expensive shares of XYZ you purchased more recently, and keep the less expensive ones you had purchased earlier. That way, you can avoid triggering a large tax bill due to capital gains on your stock. (Remember that your tax concerns are specific to you. Be sure to seek the advice of a tax professional when making decisions like this.)
If you’d rather not let go of any of the stock you’re holding, that’s also okay. It’s possible to buy the stock on margin in the open market and deliver those shares instead. This will give you better control of the tax consequences and your long-term positions. However, take into account that if you want to deliver newly acquired shares you’ll need to anticipate your assignment and buy the shares in advance of receiving the assignment notice.
Furthermore, buying stock on margin has its own risks. Margin is essentially a line of credit for purchasing stock, for which you make a minimum down payment and pay your broker an interest rate. If the market moves against you suddenly, you may be required to quickly add to this down payment in what’s termed a “margin call”. Read up on the risks of margin to use this tool wisely. Download TradeKing's Margin Agreement here.
Tip 3: Know in advance what you’ll do if the stock goes down.
You’d typically write a covered call on a stock on which you’re bullish in the long-term. If the stock goes south, it helps to have a plan in place. After all, nobody likes it when stocks go down. But once again, you have more choices than you think. Contrary to what many investors assume, selling a call doesn’t lock you into your position until expiration. You can always buy back the call and remove your obligation to deliver stock.
If the stock has dropped since you sold the call, you may be able to buy the call back at a lower cost than the initial sale price, making a profit on the option position. The buy-back also removes your obligation to deliver stock if assigned. If you choose, you can then dump your long stock position, preventing further losses if the stock continues to drop.
Tip 4: Consider buy-writes.
If you’re attracted to covered calls as an ongoing income strategy, you can buy the stock and sell the call option in a single transaction. This is called a “buy-write”. The TradeKing buy-write trading screen makes trading this strategy simple, because you can simultaneously enter your order for the stock purchase and the sale of the option.
Buy-writes offer more than convenience. For one thing, you reduce your market risk by not legging into the strategy. (When you get into a multi-leg option position in more than one transaction, that’s called “legging” into the trade.) Because a lot can happen between one trade and the next, even if they’re just a few moments apart, legging into a position can pose some additional risks.
That being said, using a multi-leg position can also be tricky. You’ll incur two commissions and it may involve complex tax treatment depending on your personal situation. Be sure to check with a tax advisor before trading a buy-write.
Tip 5: Compare “static” versus “if-called” returns.
Covered calls are a way to earn income on your long stock positions above and beyond any dividends the stock may pay. “Static” and “if-called” returns help you figure out if selling the call makes sense for your investment strategy.
“Static return” on a covered call refers to the scenario in which you sell a covered call and the stock doesn’t budge – allowing you, as the writer, to keep the premium as income. “If-called return” assumes assignment does occur and you deliver the stock at the strike price.
You should do the math for both of these scenarios before diving into covered call writing. These numbers are important to ensure you’re working towards your investing goals when implementing this strategy, and that you’ll be satisfied with your returns in the event of either outcome.
TradeKing clients can find “static” and “if-called” returns under the Options Chains in the Quotes + Research menu. Once in the chain page, just select “Covered Calls” from the drop-down menu in the Chain Type field. Keep in mind, neither of these pre-calculated projections includes commissions or fees for your trade, both of which will reduce returns.
If you’re more of a do-it-yourselfer, here’s an example of how you can calculate the different returns including commissions and fees. (These numbers assume you are trading a buy-write and use the cost basis of $50 for the stock.)
Calculating Covered Call Returns
Call sold: March 55 call
Call premium: $2.50
Stock price at time of covered call trade: $50
Number of shares traded: 100
Number of contracts traded: 1
Commission for this trade: $10.55 ($4.95 + $4.95 + $0.65)
Assignment commission - if assigned: $4.95
In conclusion…
Covered calls can be a handy strategy to generate income on your holdings above and beyond any dividends. Typically, you’ll write covered calls on stocks toward which you’re long-term bullish, but not expecting large gains in the immediate future. They can be particularly useful on stocks that are stagnant or experiencing a small dip in the short term. But be careful. As with any other option strategy, covered calls are never a sure thing. You need to understand your risks and enter the trade with a plan for all possible outcomes.