Updated: Mar 10, 2021
We don't write much about buying stocks and other traditional investing on this platform. This is for several reasons, including the fact that there's often higher risks involved with assets like stocks and the fact that that some traditional forms of investing- like savings accounts and CD accounts- just don't pay well at all. In fact, the average interest rates for these accounts are less than 1%. Without a sizable amount of money to start off with, that rate could never be used for income. However, options open up a whole new world. Not only can selling covered calls be very profitable, but suprisingly safe too.
What is a Call Option?
A call option is a financial product that allows an investor to buy an option contract (100 shares of an asset) at a preset price from the option writer (i.e. owner) by the expiration date. The buyer of an option has the right, but not the obligation, to buy the stock at the pre-set price. The seller of the option is obligated to sell the security (stocks in this case) to the option holder if the strike price is met and the option buyer so decides. The seller of the option has to hold the security and may not sell it, depending on the type of option and its use. The seller's profit is known as the premium, which is the price paid by the buyer of the option for the right (but not the obligation) to buy the securities. The amount of the premium can vary from a few pennies to thousands of dollars.
If this is confusing to you, you aren't alone. Investopedia does a great job clarifying basics of options. Visit their site for more information.
What is a Covered Call?
A covered call is an option strategy used when a stock is owned by an investor (100 shares per option contract), who can also write (sell) call options against that stock or portfolio. The writer of the option has to own the shares of the stock, so one can make a profit from a covered call strategy. Even if the stock declines below the strike price, the writer can still maintain the option premium for profit.
Many have a misconception of covered calls, namely that they are a risk management tool due to a rise in stock price. In truth, this is a common misconception, because a covered call can actually be a smart strategy for a well-diversified portfolio.
Confused? You're not alone. Read The Basics of Covered Calls on Investopedia to help you understand this derivative ever further.
Turn Covered Calls into Reliable Passive Income
Let's say you have 100 shares of a stock, with a total value of $100,000. You can sell a covered call against it and make on average 2.5% in premiums per month. That is a monthly profit of $2,500 on a $100,000 portfolio. This result assumes that the stock stays close to the strike price. The only real risk is that the writer misses out on any upside should the stock surge past the strike price. If the price goes below the strike price, the writer gets to keep the stock, plus maintains the option premium. Of course, the stock price can also fall much further, which is another risk. So we recommend buying blue chip stocks you wouldn't mind holding in the long term.
Investors can see even more income if they use stocks with more volatility. For very volatile stocks, it's not unheard of to make over 5% per month due to much higher premiums. Obtaining these kind of premiums is more common with growth stocks.
Advantages of Covered Calls
Selling covered calls has many advantages, besides just providing passive income. They can help offset downside risk or add to gains. Sometimes it makes a lot more sense to collect a cash premium instead of hoping for explosive gains from a stock during the contract period. In other words, why just wait for your stock to make gains, when you can make immediate money no matter where the price goes. It's like not renting out an empty house.
If your stock finishes above the strike price by the expiration date and the buyer decides to exercise his/her right to buy the stock at a discount, you can always buy back the stock again.
Risks of Covered Calls
Call sellers have to hold onto underlying shares (at least 100 per contract) or they'll be holding naked calls. With naked calls, your losses could be unlimited. Why? Well the underlying stock can blast upwards in price and you'd still be responsible to hand over the buyer 100 shares. An alternative would be for the seller to buy back the option positions before expiration, though that would result in more transaction costs while lowering net gains. But sometimes it’s good to take profit off the table while you still can.
Covered Call Strategies
A covered call strategy is not for everyone. For many, however, this is an amazing strategy for making some extra income. If you feel you can handle the potential complexities of this investment, I strongly suggest you visit this Charles Schwab article which wonderfully lists many profitable strategies involving covered calls. In a future post, we'll explore selling puts, which many people believe is an even better passive income engine.