Covered Call Options Strategy Explained (Simple Guide)
How would you like to make a little extra money off of a stock that you’re holding? If so, then consider a covered call options strategy.
Unlike many other strategies, the covered call strategy requires you to own the underlying stock of the options contract. As a result, it’s expensive relative to other options plays.
It also typically offers a lower return.
Still, it’s a great strategy if you think a stock you own will perform well in the long run but stay neutral in the near future.
In this guide, I’ll explain the covered call options strategy so you can determine if it’s right for you.
What Is a Covered Call Options Strategy?
There are two important parts in a covered call options strategy.
First, you have to buy (or already own) shares of stock that offer options contracts. In fact, you’ll need to own at least 100 shares of that stock since options are traded in blocks of 100 shares.
Next, you’ll sell a call option against the shares. You pick the strike price and the expiration date and as long as there’s someone who wants to buy the option, you’ll receive a credit for the amount of the sale, minus commissions.
If the stock you own hits the strike price (or goes higher) at the time of expiration, then the person who bought the call option from you has the right to buy your shares of stock at the strike price.
That means you could end up selling the shares at a below-market price. That is, after all, the nature of options.
But keep in mind: you earned a credit when you sold the call. In some cases, the credit will make up for the difference between the strike price and the market price.
Not always, though. When you write a covered call, you’re sacrificing the ability to maximize your gain if the stock really pops.
If the stock stays below the strike price at expiration, you get to keep your shares.
Why? Because the shares of stock are offered for a lower price than the strike price on the open market.
There’s no point in paying more money for shares of stock than is necessary. So the person who bought your call option will let it expire worthless.
When Would You Use a Covered Call Options Strategy?
Some investors use a covered call options strategy when they think a stock is poised to grow over the long term but probably won’t increase much in the near future.
In that case, they’ll sell the call with a strike price that’s outside of their price target for the next month or so. If the stock never hits that strike price, they’ll keep the money the earned from the sale and they’ll keep the shares of stock.
Also, some long-term investors write covered calls when they’re ready to sell. Once they’ve earned a healthy return on shares of stock they own, they’ll try to get just a little bit more of a return by selling the option.
The biggest risk here is if the stock unexpectedly tanks before contract expiration. In that case, they’ll get to keep the money earned from selling the call but they might be looking at a loss in the stock position.
Read Also: How Does A Short Call Options Strategy Work?
How Does a Covered Call Options Strategy Work?
For starters, you’ll have to ensure that you can trade options with your online brokerage. If you’re not sure, contact customer support.
Once you’ve established that you can trade options, identify a stock that you already own. Remember, you need to own at least 100 shares of the stock.
After you’ve identified the stock, follow the instructions on your trading platform to sell one or more call options against that position. Many online brokerages allow you to set limit orders for options the same way that you do for stocks.
Then, it’s a matter of waiting until expiration. If the stock moves up to the strike price, you’ll sell 100 shares for every contract at that price. If not, you’ll keep the shares.
In either case, you’ll keep the money you earned from selling the call option.
Real Life Example Using a Covered Call Options Strategy?
Let’s say you own 100 shares of Citigroup. It’s currently trading at $49 per share and you think it’s not likely to move much in the near future.
Next month’s $50 call option is offered at $1.78. You do some further research and determine that’s a fair price, so you decide to sell that call option against the Citigroup shares that you own.
That sale earns you $178 because options contracts are traded in blocks of 100 shares ($1.78 x 100 = $178).
A month passes and, sure enough, Citigroup didn’t move much. It closes at $49.50 on the date of the contract expiration.
That means you keep the $178 that you earned from the sale of the call option.
You also keep your shares of Citigroup. The person who bought the call option from you won’t want to buy shares of Citigroup for $50 when they’re offered for $49.50 on the open market.
But let’s say you were wrong. Suppose Citigroup had popped to $55 per share.
In that case, you would have sold your 100 shares for just $50 each. That’s a full $5 per share below market value.
Why? Because that’s what you promised when you sold the call option. You gave the buyer of that option the right to buy your shares at $50 each after the contract expired.
That’s one of the risks you take when you write a covered call. You sacrifice the opportunity to enjoy a nice run-up.
What Are Similar Strategies Related to a Covered Call?
Here are a few options strategies similar to a covered call:
- Short Call – Involves selling a call option when you don’t own shares of the underlying stock. It’s very risky because your losses are theoretically infinite. Your brokerage will also require a healthy margin account.
- Covered Put – If you’re short shares of a stock, you can sell a put option against those shares just like you sell a call option against a long position.
Covered Call Options Strategy Compared to Other Options Strategies?
Unlike many other strategies, the covered call options strategy requires you to own shares of the underlying stock. As a result, it can get pretty expensive.
Because of the cash outlay involved, returns are typically smaller with covered calls than with other options strategies.
However, if you’re a long-term stock investor and you also would like to generate some additional income with options, writing covered calls can give your portfolio an additional boost.
Advantages & Risks of Covered Call Options Strategy?
- Lower risk – A covered call options strategy has less risk involved than many other strategies. That’s because you’re really just sacrificing the opportunity to generate a higher return if the stock price increases significantly.
- Immediate income – When you write a covered call, you get cash deposited to your account right away.
- Opportunity loss – Traders are taught to “let their winners run.” You can’t do that with stocks when you’ve written call options against them. The strike price is the most that you’ll sell them for.
- Stock exposure – If the underlying stock tanks, you’ll still own it. Sure, you get to keep the money you earned from selling the call option, but that’s often minimal compared to a severe downturn in the underlying stock.