Investing can be simple, or it can be quite complex. For most people, simplicity is the best choice. Just invest in a total market or S&P 500 index fund, and you’ll be good to go (check out The Simple Way To Become A Millionaire). This allows you to take advantage of compounding in the stock market without worrying about being led astray by emotional investing, such as buying out of fear of missing out or, even more problematic, panic selling when the market drops. You also don’t need to research individual stocks or learn the more technical side of investing. I am a big fan of this approach. However, I recently learned about a type of option called a covered call, and so far, I have found it quite useful.
What are options?
Options are contracts that give their holder the right (or option) but not the obligation to buy or sell a security at a specified strike price by a specified date. Each contract represents 100 shares of the security, and there are two types of options: calls and puts. Calls give the holder the right to buy the security at a set price, while puts give the holder the right to sell at a set price. Purchasing an option costs a premium, and if you sell an option, you receive that premium.
What is a covered call?
A covered call is an option technique where you sell a call option on securities that you own. This means that you sell the option for someone to buy your shares at a particular strike price by a particular date in exchange for a premium. Generally you sell an out-of-the-money (OTM) call on a security you intend to own for the long term. This means that you choose a strike price that is above the current price of the security. Your goal is for the price of the security to not exceed the strike price so that the option you sold will expire and you can keep the premium without losing your shares. This would allow you to increase your earnings while keeping the same long-term strategy you are already employing. Some people liken this extra income to a dividend, and similar to dividends, it’s generally best to immediately reinvest the premiums to keep your money in the market.
Here’s a graphic showing potential profits from a covered call:
Essentially, if the stock price is below the strike price of the option at the expiration date, then you gain the premium plus whatever the value is of the underlying shares. If the stock price is above the strike price and your shares are assigned (meaning the option is exercised and you lose your shares), then you end up with the strike price plus the premium, losing out on any additional gains by the security above the strike price.
For example, say you purchase 100 shares of XYZ stock at a price of $20. You then sell 1 covered call contract (1 contract = 100 shares) that expires in 1 month at a strike price of $25. In exchange for selling the covered call, you receive a premium of $0.15 per share or $15 total. If the price of XYZ exceeds the strike price of $25 and the option is exercised, your shares will be assigned and you will receive $25 per share (even if the current price is much higher) and keep the premium. Your profit would be $25 – $20 = $5 per share ($500 total) + the $15 premium, or $515 total. If the price of XYZ does not exceed the strike price, then you keep your shares and the premium, gaining the $15. You can then sell another covered call.
Why I like covered calls
Covered calls allow you to potentially make more money on shares you already own. And since you receive the premium right away when you sell an option contract, you can put that money immediately back to work in the market.
As long as you choose a strike price above your purchase price, there is no risk of losing money even if the option is exercised. You can choose a price that is as low as you are willing to sell your shares. Of course, if you do choose a lower strike price because you’re attempting to recoup money after a security’s price falls, it is definitely possible to have those shares assigned at a price where you lose money. There is also an opportunity cost to selling a covered call. If the price rises above the strike price and your shares are assigned, then you will miss out on the price appreciation above the strike price. You should keep that in mind from the start when you sell the option.
Protect against some price depreciation
Because you receive a premium when you sell a covered call, this provides some level of protection against price depreciation of the security. For instance, in the example above, the $0.15 premium reduces the breakeven point of your investment from $20 per share to $19.85. By continuing to sell covered calls over time, you can reduce your breakeven point more and more. This makes a price drop less of a risk.
Encourage you to think about expectations for/role of securities
Ideally, when you first purchase a security, you should have a well-defined reason for doing so. What is the role you want the security to play in your portfolio (growth, dividends, diversification, etc.)? How do you expect/hope the security will perform (grow, remain stable, etc.)? Although this is how you should approach buying a security, most people do not put this much thought into it and merely buy because they are familiar with a company, have heard about it in the news, or have a fear of missing out on rapid growth.
Selling a covered call forces you to answer the important questions you should have asked when you first bought the security. Since you generally want to choose a strike price that is above the price you think the security will reach by the expiration date, this means you have to clearly define your expectations for it. If you choose a strike price too low, you limit your potential gains and are more likely to have your shares assigned. However, if you choose a strike price too high, the premium you receive will be quite small. You have to have clear expectations to balance the potential price appreciation with the size of the premium.
Provide a psychological benefit in a down market
A big benefit that I was not expecting from selling covered calls is the psychological aspect. Since you generally don’t want your securities to exceed the strike price, it doesn’t feel as bad when the market drops or stays flat. This just makes it more likely that you’ll be able to keep your shares and benefit from the premium on the options. Not feeling as big of a hole in your stomach when stocks crash is a huge blessing for me.
Why I don’t like covered calls
The biggest, and pretty much only, problem with covered calls is that they cap your potential upside. If one of your securities suddenly takes off, you won’t be able to benefit from the price spike. Instead, you will only receive your strike price plus the premium. This can be quite vexing, especially since the premium is often significantly smaller than the price appreciation. It is possible to close out your options by buying them back if you think that the price may continue to rise. However, the price to close the options is usually prohibitive, so it often does not make sense to do this in my opinion. Assuming that you chose a strike price slightly above the price you anticipated your security might reach, I think it’s better to consider having your options exercised as selling at a high point, even if it’s not quite as high as you might want. For all you know, the price could come crashing back down at some point in the future, and who’s to say you would have sold when the price was higher?
Overall, I think selling covered calls is a great tool for generating additional income with securities you already own and plan to hold for the long term. It is a low-risk technique that won’t leave you on the hook for countless dollars. The worst case scenario is that you will sell your shares at a price you have defined. The best case scenario is that you keep your shares and the option premiums. As long as you are choosing a strike price well out of the money, this is the more likely scenario. Based on my experiences so far, I think selling covered calls can be a good way to complement your regular trading strategy. However, how and if you choose to use them is up to you.