Covered calls are a great way to generate extra income from a stock portfolio. While the strategy is fairly straightforward, there are many nuances that can make managing a covered call position challenging—especially when the stock pays dividends or if the price is approaching the strike price near expiration.
In this article, we will take a closer look at covered calls, various possible outcomes, and actions that you can take to address any issues that arise over time.
Covered Calls 101
Covered calls are a great way to generate income from existing stocks that you own. The option buyer will pay you a cash premium for the right to purchase stock from you at a set price until the option expires. If the option expires, you keep the premium and the stock. If the option is exercised, you keep the premium and sell the stock at the agreed-upon price.
Let’s take a look at an example:
Suppose that you own 100 shares of Acme Co. at $10 per share. You sell one covered call with a strike price of $12 that expires in one month with a $1.25 premium. You immediately receive $125 in cash (100 shares x $1.25) minus any commissions on the trade, which varies depending on your broker.
There are three possible scenarios:
- The stock rallies above $12 and your shares are “called away”, which means that you must sell them at $12 to the option buyer. You will earn a 32.5 percent return on the position (20 percent gain in the stock plus the premium), but you lose out on any upside beyond that amount.
- The stock drops below $10 and you keep your shares but have unrealized losses on the stock. The good news is that the option premium helps offset these losses.
- The stock trades over $10 but below $12 at expiration, which means you get to keep your shares and the premium. This is the most profitable and best-case scenario since the stock appreciated in value and you can keep the premium.
Managing Covered Calls
Covered calls are managed differently depending on how they’re used in a portfolio. If you are using them to exit an existing stock position, you may simply choose an option and execute the trade. There’s no need to spend time picking stocks or managing the position if your goal is to sell the stock. But, most investors use covered calls to generate an income.
In this case, there are four steps to covered call writing:
- Selecting a Stock: Covered calls can be written against most blue-chip stocks, but selecting the right stocks can help maximize income generation and minimize risk.
- Selecting an Option: Choosing the right strike price and expiration helps maximize the profitability of the trade while minimizing the risk of the option being called away.
- Placing the Trade: If you already own the stock, you simply need to “Sell to Open” the option you’ve selected. You can also buy the stock and sell the option using a single trade ticket if you don’t own the stock. Most options are exercised just prior to expiration on the third Friday of each month, but there may be exceptions for special situations. As the option seller, you don’t have to do anything at expiration if you don’t mind selling your shares.
- Managing the Position: Many traders closely monitor both the stock and options to adjust the position as expiration approaches. It may be necessary to roll out options that are at risk of being called away.
Managing covered call positions can be challenging given the wide range of possible scenarios. If you’re looking for a simple approach, Snider Advisors provides a framework for selecting the right stocks and options, as well as managing the trades to maximize profitability and minimize risk.
How to Handle Problems
Suppose that a covered call position is at risk of being called away because the stock price is rapidly moving towards the strike price. You might not want this to happen because it could lead to realized capital gains. Or, you might not want to deal with the pain of repurchasing the stock for the portfolio.
There are several possible actions that you can take:
You could take no action and let the stock be called away at or before expiration. In most cases, you could still realize a net profit on the position, if the call option was out-of-the-money. The downside is that an unrealized gain can become a realized gain for tax purposes for the year.
You could closeout or unwind the position by buying back the covered call and either retaining or selling the stock. Often times, this is a good option if there’s an ex-dividend date approaching (closeout) or if the stock price moves sharply higher and you want to lock in gains immediately (unwind).
Or, you could roll out the position by buying back the covered call and then selling a new call at a later date, higher strike price, or both. These strategies work best when the price is approaching the strike price and you’d like to keep the stock, and you may adjust the next strike price based on sentiment.
These are all different options for managing a covered call position that may not be going in your favor. The right decision depends on your sentiment on the underlying stock (bullish or bearish) and your income goals.
The Bottom Line
Covered calls are a great way to generate income from a stock portfolio. While everyone hopes that the trade goes according to plan, there are some cases where you may be at risk of having to deliver stock. The good news is that you can take several actions in these cases to adjust your position.
If you’re overwhelmed by managing covered calls, you may want to consider Snider Advisor’s well-defined approach to the strategy. Sign up for a free course today to learn more about how to generate an income from a stock portfolio without spending all of your time creating and managing positions.