“Writing covered calls” is a term many outside the financial industry don’t understand. Simply put, it’s a strategy to produce income by writing (selling) options against shares of stock you currently own. Typically, you sell one contract for every 100 shares of stock. In exchange for writing (selling) call options, you collect an option premium. The trade-off is that when your call option is exercised, you deliver your shares of the underlying stock.
You have two choices depending on your goals. First, you design the option so the buyer actually buys your stock. Or, you sell the option at a price far from the current price. This keeps the buyer from actually buying your stock. You already own the underlying stock, which means your potential obligation is “covered”. (Hence the strategy’s name, “covered call” writing.)
Why write covered calls?
When you write (sell) covered calls, you’re usually hoping to keep your underlying stock. It’s also a good way to generate extra income via the option premium. You want the stock price to remain below your strike price so the buyer isn’t motivated to grab the shares away from you by exercising the option. This way, the options expire worthless. You keep the entire option premium at expiration, and you also keep your shares of the underlying stock.
When your stock’s price is neutral or dropping, but you still want to hold 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. You probably want the value of your shares to increase, just not enough to hit your covered call’s strike price. This scenario lets you keep the premium from your options sale, and you 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. 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 sell has a 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 the March expiration, the call is “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). The option buyer most likely wouldn’t exercise the call. The call option expires worthless. You pocket the $250 premium AND keep your 100 shares of XYZ stock. Keep in mind, as long as the options you sell don’t get exercised, you can repeat this maneuver from month to month. You can sell additional covered calls against the same shares of stock.
What happens if the stock shoots through the roof?
If you write a covered call and the underlying stock shoots skyward, exceeding the option’s strike price, the buyer has reason to exercise the call option. Afterall, buying the stock for the strike price is cheaper than buying it in the open market. We call this being “in-the-money.” In this scenario, your shares are probably called away. You might be sad to part with your stock and miss out on some gains, but there are some benefits. You can employ strategies like buying the option back if it gets too close to your “exercise” price. Then you can sell another call option out at an even higher price to prevent that sale. It isn’t a fool proof strategy, but if you manage your option strategy properly, you can should be able to avoid that risk.
What are the risks in covered call writing?
Although writing (selling) covered calls is a fairly conservative option, there are risks. Remember you’re wearing two hats, a call seller AND 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. However, when 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.
* The option information provided on this website is for informational purposes only and should not be construed as an offer to buy, sell or hold option contracts.