The Purposes of Selling Covered Calls
When selling covered calls, there are two objectives. The first purpose is to profit from time decay in option contracts. When you sell options, time decay works in your favor, ensuring that your realized returns for the year are between 3% and 10%. The second factor is the stock’s unrealized gains. The greater the implied volatility of a stock or index, the larger the premium received when selling call options. The best aspect is that you can profit from covered calls without having to sell your stock.
Selling OTM (Out of the Money) Covered Calls Strategy
The idea would then be to choose an OTM (Out of the Money) strike price above the current stock price roughly 30 days out and collect that extra premium to produce monthly income. The best thing is that if you are anxious before the expiration date, you can get out by buying back the call options or rolling them over to the next month, provided the price action does not move up towards the strike price you chose.
Selling a $35 strike price call option on a $30 stock, for example, would result in the stock gaining more than 10% in 20 trading days within a month. Unless the stock is recognized to be a high flyer, it’s not very likely. This method works well with equities that you don’t want to sell and that aren’t high flyers. Put in a large margin of error and you’ll make a lot of money for free.
Selling ATM (At the Money) Covered Calls Strategy
In a sideways market, this method is great. This is one of those instances where your market view is either neutral or unfavorable. This is used to protect against downturns while maintaining a healthy cash flow. Thus, use a stock that you don’t mind selling for this method. If the stock rises, you may miss out on gains. Although this strategy may ensure a higher percentage of monthly returns from options premiums, the stock upside potential may be limited or non-existent due to the method’s implementation. The premium from this method, on the other hand, can be substantial. When there is no foreseeable catalyst for the stock price to rise, this method can be effective.
Selling Covered Calls Example
Here’s an illustration of how to sell in order to open a covered call. If you hold 100 shares, you are simply speculating that the stock will not rise above a particular price, known as the strike price, at some point in the future. It is the monthly option in this case. This is how it appears on the diagram.
We’ll get the premium and keep the stock if the stock doesn’t rise over the strike price of $35. The premium is $0.4 per call, or $40 total. Assume you bought the shares for $32.56. In 28 days, that’s a 1.2 percent income. If we do this every month and the 1.2 percent rate stays the same, we’ll make 15% per year. This is solely based on option premiums.
What Happens if Things Gone Wrong?
When the stock price has risen over the strike price near the expiration date, I’m not sure what I can do about it. The goal is to minimize the chances of the shares being called away. When the stock price is over the strike price at expiration, the shares will be called away. This isn’t ideal because you’ll miss out on potential gains and be compelled to sell your stock. We can try rolling a covered call.
Rolling Covered Calls
Rolling a covered call is purchasing back a call that you sold at a loss and selecting a higher strike 30 days or longer out and selling that higher strike for a greater or equivalent premium. This is highly dependent on the stock’s implied volatility, but in most circumstances, rolling a covered call becomes ideal as the expiration date approaches.
Here’s an example:
- We have a total of 100 shares of stock.
- We’ve already sold a $32 covered call expiring November 19th.
- The stock is currently trading at $32.56, and the $32 call is ITM (in the money).
- We can “Roll Up and Roll Out” if we don’t want the shares to be called away. When you roll up a covered call, you choose a covered call with a higher strike price. Rolling out a covered call entails picking a covered call with a longer expiration date than the one we’ve already sold.
How to Find the Right Covered Calls to Roll
Let’s take a look at the scenario.
- The November 19 $32 call is currently trading at $1.18 per call, for a total of $118.
- A December 10 $33 call is currently trading for $1.2 per call, for a total of $120.
Because of the following advantages, this would be a good fit for us.
By extending the covered call for another 21 days, it’s practically an even trade.
When we sold the November 19 $32 covered call, we kept the entire premium.
It also prevents stocks from being immediately called away.
Depending on the volatility of a stock, the appropriate strike price for monthly options is roughly 10-20% away from the stock price. You want to set a strike price that is further away from the stock price in stocks with high volatility and high premiums, so that you can make extra money and avoid having your shares called away.
The implied volatility in the case above is roughly 34%. The proportion of monthly premium income is approximately 1.2 percent. We can sell the monthly options each month and earn 1.2 percent if the shares aren’t called away. As a result, the options premium alone accounts for 15% of the investment annually.
Summary of Selling Covered Calls
Stock prices do not always correspond to projections. Forecasts and targets are also open to revision. The decision to sell an OTM, ATM, or ITM call depends on the type of stock and personal risk tolerance. The goal is to be able to do it repeatedly and safely. As a result, covered call investors should be conversant with simple rolling strategies in the event that they are required. We must be prepared, like with everything else in life, to deal with calamities or adversity if they occur. Unfortunately, there is no correct or incorrect method for rolling a covered call. Rolling is a personal decision that each investor must make for himself.