With traditional investing, you buy stocks, hoping the price goes up, so that when you eventually sell you can make a profit. While this type of investing can make you money, it doesn’t always have a payout, and even when it does, you don’t always have a livable income from that payout. There are other ways to invest that will generate a steady income, however. One of the best ways is to write covered calls.
Covered calls are a specific income-producing investment strategy that allows more flexibility for short-term and long-term capital gains, while also hedging investments against a volatile market.
But if you’ve never written a covered call before – or if you have, but you’re looking to gain a higher yield – there may be a few things you need to know first.
What to Know About Calls and Options
Covered calls are a type of option trading, and while the strategy does involve selecting stocks, the approach is a little different. Here is a breakdown of some of the terms you may need to know.
A stock option is a right that can be bought and sold. There is usually a buyer and a seller involved in the process.
A covered call is one type of option. The buyer purchases the right to buy a certain number of shares of stock that the seller owns at an agreed-upon price. This happens at any time before the option expires. The buyer doesn’t have to buy the stock, but he has the right to. Even if he doesn’t buy it, the seller keeps the money they were paid when they sold their option.
The option price, which can change as the stock moves in the market, is the price the option is bought or sold for. As with a stock, there are two prices: “Bid” and “Ask.” The buyer and seller agree on a strike price when the option is bought/sold.
For example, if you owned a stock currently trading around $43 per share, you could sell a call option that expires in June and has a strike price of $45. Two things can happen:
- If your stock stays below $45 before the call expires (in June), you keep both the stock and the amount you sold the call for (which is called the premium).
- If the stock rises above $45 before the call expires, the buyer exercises the call, buying the stock from you for $45 per share. You get the money from the sale of the stock and the premium, but you no longer own the stock.
A buyer has the right to exercise their option up until the expiration date. If that happens — meaning the stock is called away — the shares are automatically delivered to the buyer. Options typically expire on the third Friday of every month.
As a general rule when you buy a call option, you need the share price to move higher in order to make money and you also need it to happen within a relatively short timeframe. With each day that passes, options decay in value, which is bad for the buyer (but great for the seller).
This makes call options a great choice for sellers looking to make a profit off of stocks they already own.
How to Write Covered Calls
If you already own stocks, writing covered call options is a great way to boost your yield with lower risk.
To write a covered call option, you:
- Choose a stock you already own and for which there is an options market (alternatively you can buy shares of stock you want to own)
- Decide how many calls you want to write (sell)
- Pick a strike price
- Pick an expiration date
- Find a buyer
Keep in mind that each call gives the owner the right to buy 100 shares of a stock or to sell 100 shares of a stock they already own. If you write two calls, that would be 200 shares, for instance.
Make sure you own enough shares of a stock to write a call, or consider buying more. Never buy a stock that you don’t want to own, as there is no guarantee it will be called away. If you don’t own the stock, then the call sale is “uncovered” or “Naked.” (This strategy is significantly riskier.)
Since the option will only get exercised if the stock rises, the best stocks to use (assuming you want to keep them) are stocks that you don’t think will go up right away. Stocks in sideways trends are good candidates.
If you sell calls expiring soon, there’s less risk that your stock will rise above the strike price and get called away, but there’s a trade-off. If you sell longer-dated calls, your premium will be higher.
Make sure you understand the risk with short-term and long-term expiration dates and how they affect your premium and stock ownership once or if the call is sold.
Some Advice for Better Yields
If you want to make sure that your premiums have a higher yield, here are a few rules of thumb:
- Write covered calls on stocks with dividends
- Sell at a strike price above the current market price of the stock
- Select near-term expirations and sell them consistently
- Choose an underlying stock with an at-the-money option (the strike price is similar to the underlying stock’s price)
One warning: Avoid selling call options without owning the underlying stock. Only sell covered calls for stocks you own.
Also be wary of any taxes that need to be paid after a sale. If you sell a covered call and the option expires, the gain is considered a short-term capital gain, which is currently taxed as ordinary income.
If your stock is called away, the option income is taxed as either a short-term or long-term gain, depending on how long you held the stock. This will affect the overall income you receive from your call.
Writing covered calls can be an excellent strategy for investors who want to make a profit off of stocks they already own (or want to own) with higher yielding and lower-risk results.
For those that want to make a generous profit off of writing covered calls, it’s important to choose the right stocks. Those that are heavily traded with steady movement through the market (and that won’t rise or fall too quickly) are good choices.
If you’re interested in stock selection or wanting to learn more about covered calls, be sure to check out our free courses on covered calls and stock options. Since 2002, we’ve taught thousands of investors how to write covered calls and implement the Snider Investment Method on their portfolio.