Before diving into the complexities of what a covered call trade is and how it can be used to generate portfolio income lets first define what an option contract is and what it means to each party involved. There are two main types of options, call options and put options. A call option is a contract that gives the holder (buyer) the right, but not the obligation, to buy a security at a specified price for a certain period of time.
Buying one call stock option gives the purchaser the right to buy 100 shares of a stock. If the stock price is greater than the options exercise (strike) price the option can be exercised and the option buyer will make a profit based on the difference between the current price and the strike price. When this happens the option is considered to be ‘in the money’. If the price of the stock is below the strike price on expiration the option becomes worthless or ‘out of the money’.
It is possible for an investor to either buy or sell options; selling naked calls means an investor sold a call option without owning any underlying stock to offset option. Selling naked calls is a very risky endeavor. If an investor sells a naked call and the stock dramatically rises above the options strike price the investor will owe 100 times the difference between the stock price and the options strike price.
Both buying call options and selling naked call options are speculative strategies where the investor stands to only make a profit if they correctly guessed the direction of the stock’s price.
Between the date the option contract is initiated and the date it expires the price of the stock will constantly fluctuate. The more a stocks price is expected to fluctuate over this time frame the harder it is to predict whether or not the option will be in the money at expiration. To account for this, options are priced at a premium, and that premium declines as the expiration date nears. All else held the same, an option expiring in one month will be worth more today than tomorrow if the stock price remains the same. For more detailed information on how options are priced read The Greeks: From Past to Present.
Covered Calls Explained
What is a covered call? Let’s now look at an example. XYZ stock is trading at $52 today; a call option to purchase XYZ at $55 one month from now is priced at $3. To initiate a covered call on XYZ stock an investor would purchase 100 shares of XYZ and sell a call option which obligates him to sell XYZ at $55 one month from now if exercised by the option buyer. For simplicity we will ignore commissions.
Pros of Selling Covered Calls for Income
– The seller receives the premium from writing the covered call immediately on the date of the transaction, in this case $300. If the price remains below $55 at option expiration the seller will keep the 100 shares of stock and the $300 he received for the option.
– If the price of the stock is over $55 at option expiration the call option will be exercised. At this point the 100 shares of stock are sold, the investors profit is equal to the $300 received for selling the option plus the $300 in capital appreciation (100 shares * ($55 sell price – $52 purchase price)) for a total profit of $600.
– The premium received can help offset a downward move in the stock price. In this example the investor purchased the shares at $52, if the stock were trading at $49 on expiration and the investor decided to sell his shares the total profit would be $0. The $3 loss on the shares of stock is offset by the $3 received in option premium.
Cons of Selling Covered Calls for Income
– If the stock rises well above the strike price, the seller does not enjoy the full appreciation. The seller’s profit is limited to the premium received plus the difference between the stocks purchase price and the options strike price.
– The option seller cannot sell the underlying stock without first buying back the call option. A significant drop in the price of the stock (greater than the premium) will result in a loss on the entire transaction.
– Premium amounts are based on the historical volatility of the underlying stock. Stocks with higher option premiums will have a greater risk of price fluctuation.
– Losses due to downward moves in the underlying stocks price are only limited by the amount of premium received.
Is Selling Covered Calls “Worth It”?
As you can see, selling covered calls for income offers both advantages and disadvantages to outright stock ownership. They can be a great tool to generate additional income from an equity portfolio; however using only a simple covered call strategy can get you into trouble due to its limited upside potential and limited downside protection.
Strategies using options to generate income can be as simple as selling covered calls, while others add strict rules and processes to manage income, emotion and risk. If you are looking to add an income producing strategy using options, compare the risk/reward profiles of every strategy and pick one that matches your objectives, risk tolerance, time horizon and temperament. For more information on using options in your portfolio read our free special report: Myths & Misconceptions About Exchange Traded Options.