Covered calls are one of the more conservative trades an investor can make yet these trades can still make returns that beat the broad market, usually when a stock is stagnant. This kind of trade should not be considered unless the underlying stock (or ETF) is one that the investor is willing to own.
To place a covered call, an investor sells a call on a stock he already owns or buys stock and sells a call at the same time. Either way, the position consists of paired groups of 100 stock (or ETF) shares and one sold call option. The call is considered “covered” because you own the stock as well.
Because you sold a call, your cost basis is lower than an investor who just bought the same stock at the same time. Your break-even price is the stock’s entry price minus the amount you received for selling the call.
As long as you have a sold call in your account, you will need to keep 100 shares of the stock in your account to ensure you don’t take any losses if the stock rises above the strike price.
A covered call has a limited upside and the downside potential includes all the cash required to open the trade, but that is true of any stock purchase. In reality, a covered call always has less risk than buying the same stock without selling a call. In return for that safety, you don’t get the same reward for a stock that makes a big move higher, so this kind of trade is not a great idea for stocks with high upsides. Instead, this is a good strategy for stable stocks that you are mildly bullish on.
There are only two outcomes for a covered call trade. If the stock is higher than your sold call’s strike price at expiration, then you will be assigned. As the seller, this means you will be paid the strike price but have to deliver 100 shares of stock to the call holder at the agreed upon strike price. If you end up being assigned on your sold call, you will simply give up the shares that you own, but your trade should be structured in such a way that you still make a comfortable return if this happens.
If the stock is below the sold call’s strike price at expiration, then the sold call will expire worthless and you will retain your stock position. Since you sold the call, you got cash up front that is yours to keep along with the stock. It is even possible for the stock to finish at expiration above your break-even point but below the strike price, which would mean you make gains on both sides of your trade. If the stock is below your break-even point at expiration, you will still have your stock, which means you are losing money. However, any losses will always be smaller than for an investor who only bought the stock at the same time.
After expiration, if you still have your stock position, you will probably want to reevaluate your situation. If you no longer think the stock is worth owning, this is your opportunity to take profits or cut your losses.
If you still like the stock, you can hold it indefinitely or perhaps sell another call to establish another covered call position. If you want to keep your stock but the sold option is in-the-money, you will want to act before expiration. One popular strategy at this juncture is rolling the sold call out to expire farther in the future or at a higher strike price or sometimes both.
To roll out a covered call trade, buy back your original sold call then sell another call with later expiration or a higher strike. Rolling to the same strike price in a later month should result in a credit for the roll, while rolling to a higher strike may cost some cash up front but usually has a higher upside.
As long as you hold the stock portion of a covered call, you will earn any dividends the stock pays and have full voting rights, just like a normal shareholder.
Since you sold a call, you have the obligation to deliver the shares at any time before expiration if you are assigned and this could theoretically happen at any time. If it does, then you will be paid the strike price for your shares, just the same as at expiration. Often this happens the night before the underlying stock trades ex-dividend and may also happen in the days right before expiration.
A conservative covered call will sell a call that is initially in-the-money and aim to get the lowest possible cost basis and break-even point. This conservative position will typically have a large amount of downside protection but not a tremendous profit opportunity. The goal of a conservative covered call is to have the sold call expire in-the-money and lock in a profit.
More aggressive covered calls will sell a call that is out-of the money. With this more aggressive stance, the credit for selling the call will be less, so the break-even point will be higher and the trade will have less downside protection, but the upside is larger this way. Often the ideal result for an aggressive covered call trade is to have the sold option expire out-of-the-money, allowing the investor to pocket the cash and sell another aggressive call soon after.