Overview
This post will discuss the purpose of selling covered calls as well as how to use different types of calls in different situations to increase the return on your investment portfolio. Finally, it addresses the question of whether or not you should roll a covered call, as well as the specifics of how to do so.
Why Should You Sell Covered Calls?
Selling covered calls is primarily done in order to provide a consistent monthly revenue stream, providing that the monthly options are sold. In essence, when you sell a call option, you are locking in the current price of the asset, allowing you to profit from the price in the short term. This method is particularly advantageous when the outlook for the stock in which you invest is not particularly bullish and the price of the stock has been stagnant for an extended period of time. This implies that booking short-term profits would be preferable to continuing to hold the stock.
When it comes to selling covered calls, there are two main goals. The main goal is to profit from the time decay of option contracts in order to maximize profits. When you sell options, time decay works to your advantage. Time decay refers to the fact that the value of options will decrease in the days and weeks ahead, assuming that all other factors remain constant. Because you are the option seller, this is favorable to you. It guarantees that the option premiums you receive on a monthly basis might profit you anywhere between 1 percent and 3 percent.
When the stock price rises, the second factor to consider is the stock’s unrealized gains. The greater the implied volatility of a stock or index, the greater the premium obtained when selling call options on that stock or index. The most advantageous part is that you may earn covered call premiums without having to sell any of your stock positions.
Strategy for Selling Out of the Money Calls
The objective would then be to select an OTM (Out of the Money) strike price that is somewhat higher than the current stock price around 30 days out and collect that additional premium in order to generate monthly revenue. The amount of premium that you were able to pocket by selling call option contracts on the stock would be your profit as long as the stock’s price remained below the strike price of your covered calls. Best of all, if you get nervous before the expiration date, you may bail out by purchasing back the call options or rolling them over to the next month, provided that the price of the stock does not move above the strike price you selected.
Selling a call option with a strike price of $55 on a $50 stock, for example, would result in the stock increasing by 10% in 20 trading days within one month. Unless the stock is widely regarded as a high-flyer, this is not a plausible scenario. This approach of “selling out-of-the-money covered calls” is effective when dealing with stocks that you don’t want to sell but that aren’t particularly volatile. The goal is to keep the stock. In the meantime, you want to pocket the options premium every month as extra income.
Strategy for Selling at the Money Calls
This strategy works extremely well in a sideways market. When you have a neutral or unfavorable market outlook, this is one of those circumstances. This technique is utilized in order to hedge against downturns while keeping a solid cash flow. As a result, for this strategy, choose a stock that you don’t mind selling. If the stock rises in value, you may lose out on potential gains.
The application of this strategy may result in a higher percentage of monthly profits from options premiums. However, the upside potential of the stock may be limited or non-existent as a result of the strategy’s implementation. In the worst-case situation, you will forfeit any potential gains that may have accrued beyond the strike price of the call contract. On the other hand, the premium associated with this strategy can be significant. It is possible to achieve success with this strategy when there is no obvious catalyst for the stock price to rise.
Example of Selling Covered Calls
As an illustration, here’s how to sell in order to open a covered call transaction. If you own 100 shares of stock, you are simply wagering that the stock will not rise above a certain price, known as the strike price, at some point in the foreseeable future. In this particular instance, the monthly option is selected. Weekly options are also an alternative. Although it requires significantly more maintenance and can be labor-intensive, it is less cost-effective. The diagram depicts the situation as follows.
In this example, you paid $147.93 per share for 100 shares of AAPL. You received $180 for selling a $155 call.
If the stock does not rise above the strike price of $155, we will receive the premium and retain ownership of the stock. The premium is $1.8 per call, for a total of $180. Consider the following scenario: You purchased the shares for $147.93. That equates to a 1.2 percent income in 37 days. If we repeat this process every month and the 1.2 percent rate of return remains constant, we will earn 15 percent per year. This is entirely based on the option premiums that have been received.
What If Something Goes Wrong?
When the stock price has risen above the strike price as the expiration date approaches, I’m not sure what I can do. The purpose is to reduce the likelihood of the shares being called away. Always keep in mind that covered calls are the ideal alternative for long-term investors who own stock in financially strong corporations. The shares will be called away if the stock price at the time of expiration is greater than the strike price. The downside is that you will miss out on possible gains and will be forced to sell your stock as a result. We could try rolling a covered call to see how it goes.
Example of Rolling Covered Calls
Using the previous example, we purchased AAPL at a price of $147.93 per share. In addition, we sold a $155 call for $1.8. The stock is currently trading at $155.50, two days before the option expiration date. The $155 call is currently trading at $1.5. The stock’s price has now risen above the strike price. There are two days left until the option expires and may be assigned. Buying back the $155 call at $1.5 and simultaneously selling another call with an expiration date of 30 days out at $1.50 may be a viable option for us in this situation.
When you roll a covered call, you are essentially purchasing back a call that you previously sold and selling another at a different strike price at least 30 days out for a higher or equivalent premium. Depending on the implied volatility of the stock, this may or may not be advantageous, but in most cases, rolling a covered call becomes beneficial as the expiration date approaches.
Here’s an illustration taken from the diagram above:
- We have a total of 100 shares of Apple stock, which we purchased at a price of $138 per share.
- We’ve already sold one covered call at $145 with an expiration date of November 19th.
- The stock is currently trading at $148.35, and the $145 call is currently in the money (ITM).
- In the event that we do not want the shares to be called away, we can “Roll Up and/or Roll Out.” When you roll up a covered call, you select a covered call with a higher strike price than the one you originally selected before. Rolling out a covered call entails selecting a covered call with a longer expiration date than the one we’ve already sold.
How to Identify the Most Appropriate Covered Calls to Roll
Consider the following example, which is based on the previous illustration:
- The November 19 $145 call is currently trading at $4.05 per call, for a total of $405.
- A December 17 $145 call is currently trading for $6.13 per call, for a total of $613.
As a result of the following advantages, we believe this would be an excellent candidate for us.
By extending the covered call for an additional 37 days, we were able to collect $208. $208 is the difference between $613 and $405. When we sold the $145 covered call on November 19th, we kept the entire premium received. It also prevents stocks from being immediately called away. Even if the stock is called away, we get to keep all of the option premiums we earned, on top of the gains we made from the difference in stock prices.
Selling Covered Calls in a Nutshell
If you are just getting started, covered calls may be a good place to begin your options trading journey. A popular strategy for long-term investors looking to generate additional income from their portfolios is selling covered calls. The goal is to be able to do it repeatedly and safely. The decision to sell an OTM, ATM, or ITM call is based on the type of stock and the individual’s risk tolerance. The most important factor in achieving success with covered call strategies is selecting the right company to sell the option on. Furthermore, choosing the most appropriate strike price is critical to the success of the strategy.
So long as the price of a stock remains below its strike price, simple covered calls are the most effective. Stock prices do not always match up with forecasts. Forecasts and targets are also subject to change. Consequently, the profit potential of this strategy is the most significant risk associated with it. If the stock increases in value too quickly in the short term, you will lose out on potential gains. It also serves to limit potential losses to a certain extent, as you cannot lose the premium you receive from selling the option.
Managing Risk
We must be prepared to deal with calamities or adversity if they occur, just as we must be prepared to deal with everything else in life. Unfortunately, there is no “right” or “wrong” way to roll a covered call in this situation. The decision to roll is a personal one that must be made by each individual investor.
Covered calls is the best option for long-term investors who own stock in financially sound companies. Trading options is challenging and not suitable for everyone. Prior to making any decisions, determine your level of risk tolerance. Covered calls, when used properly, can assist in risk management by potentially increasing profits while simultaneously decreasing losses.