How to Use Covered Calls as an Investment Strategy

Overview

This post explains what a covered call is and why it can be helpful. It demonstrates how to construct various covered calls with examples. The final section discusses whether or not the strategy can provide investors with a steady stream of income.

Covered Calls: An Example of What They Are and How They Work

An option trading method known as “covered calls” involves an investor who already has a long position in an asset selling call options on that asset.

For example, a stockholder who owns 100 shares of a $75 stock could engage in covered call trading. The stockholder sells one call option contract against those shares with an $80 strike price. The investor receives the option premium as income.

On the day the call option expires, the price of the underlying stock has risen to over $80. The call option’s $80 strike price obligates the investor to sell their shares at that price.

If the stock price stays below $80 when the call option expires, the investor keeps the premium as income. In addition, the person retains ownership of the 100 shares of stock.

Are Covered Calls a Bullish or a Bearish Strategy?

The covered call trade is a neutral strategy because it involves both long and short positions in the same asset. Based on the options trader’s outlook, it can be employed in either a bullish or bearish market.

If a trader expects the stock price to rise, they can profit from this by selling a call option with a higher strike price. If a trader is negative on a stock, they can profit from a decline in the stock price by selling a call option with a lower strike price.

How About a “Poor Man’s Covered Call” Then?

As a rule, a covered call position consists of a stock purchase and the subsequent sale of a call option. The “poor man’s covered call” technique entails buying and selling two different call options.

The investor will purchase long-term call options and sell short-term call options on the same underlying asset. This technique has the benefit of requiring less money upfront. The term “Poor Man’s Covered Call” stems from this principle.

Examples:

Covered Call:

The covered call option strategy requires a total investment of $13,960 to buy shares of AAPL. 

  • With a price of $142.5 per share, an investment in 100 shares of Apple will cost $14,250.
  • Receive $290 by selling a $147 out-of-the-money Call option with an expiration date in the next month for $2.90 per contract.
  • The total cost of the transaction is $13,960. ($14,250 – $290)

Poor Man’s Covered Call

The minimum investment for a “Poor Man’s Covered Call” on AAPL is $2,648, less than one-fifth of the total investment required by the covered call.

  • Buy a $120 call option that expires 6 months later for $29.38 per contract, totaling $2,938.
  • Sell a $147 out-of-the-money call with a 30-day expiration for $2.90 and collect $290.
  • The total cost of the transaction is $2648. ($2,938 – $290)

In What Situations Would It Make Sense to Use a Covered Call?

When an investor believes the stock price will stay the same or fall, they should sell a covered call. Even if the stock price falls, an investor can profit by selling a covered call and collecting the premium.

However, the investor must sell at the call option’s strike price if the stock price rises above it at expiration. As a result, the investor will forego any future appreciation in the share price.

Example

Purchased Amazon shares at $97 per share. Sold a $102 call option expiring in one month for $3 per contract.

In the event that Amazon stock is trading at $100 per share on the option’s expiration date, you will be able to hold the shares and keep the entire $3 premium, or $300.

If Amazon is at $103 on the option’s expiration date, you must sell it for $102, the call option’s strike price. Your net gain amounts to $800, or $8 per share. ($102 – $97) + $3 (call option premium) 

On the option’s expiration date, even if Amazon stock had risen to $110, you would have to sell it for $102. Your final profit is still $800, or $8 per share. ($102 – $97) + $3 (call option premium). A buy-and-hold investor, on the other hand, could make a profit of $1,300 in this scenario.

Why Would Someone Sell an In-the-Money Covered Call?

Investors may sell an in-the-money covered call if they believe the stock price will remain stable or decline. If an investor sells a call option that is currently in the money, they will receive a higher option premium than if they sold a call option that was currently out of the money. If the share price doesn’t go as planned, this strategy can still generate income for the investor.

When a Covered Call is in the Money, What Happens?

When a covered call option is in the money, the investor has the obligation to sell the shares at the option’s strike price. To put it another way, if the stock price rises above the strike price, the investor must sell their shares at the strike price, regardless of how much higher the stock price is than the strike price.

Are Covered Calls a Smart Strategy?

Investors looking to generate income from their long stock positions may benefit from covered calls. By selling a covered call, the investor can benefit from the option premium and limit their losses if the stock price goes down. The investor will sell their shares at the call option strike price if the stock price rises above it.

Is It Possible to Lose Money Using Covered Calls?

The main risk associated with covered calls is that the investor will be forced to sell their stock at the strike price at which the call option was originally sold. Consequently, the investor runs the risk of missing out on gains if the stock price rises sharply. Keep in mind that high-growth stocks are not good candidates for a covered call strategy.

In addition, using covered calls can help mitigate some of the losses incurred by a decline in the stock price. On the other hand, its protective abilities are limited. The level of protection provided is equal to the premium received for the underlying call option. If prices continue to drop, investors will need to change tactics to protect their investment.

Covered calls are risky and can result in a financial loss.

How Feasible is It to Rely on Income from Covered Call Trading?

Selling covered calls as a primary source of income is feasible but should be viewed as a risky investment strategy. It’s important to remember that selling covered calls exposes the investor to additional risk and could result in a loss of profit if the stock price rises sharply. Likewise, if the stock drops significantly, the investor could suffer financial losses. Therefore, before deciding to make a living solely from selling covered calls, you should be aware of the risks involved.

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