Table of Contents
What Are Covered Calls and How Do They Work?
Covered call writing involves selling the right for someone to buy your stocks at a set price by a future expiration date. You collect an upfront premium, which lowers your cost basis. If the option is exercised, you sell at a profit. If not, you keep the premium.
When you own 100 shares per call contract, it’s considered “covered” because you can deliver the shares if needed. With uncovered calls, you don’t yet own the underlying stocks.
Step-By-Step Process of Writing Covered Calls
For example, say you buy 300 shares of XYZ at $48 in August. You then sell 3 covered call option contracts with a $50 strike expiring in January.
The buyer pays you a premium of $3.50 per share, totaling $1,050 upfront. By January, either the calls execute at $50 per share or they expire worthless. Either way, you keep the premium.
Benefits of Using Covered Calls
Covered call writing offers several advantages for stock investors:
- Establishes a profitable sale price when you purchase stocks
- Reduces risks by lowering your net cost basis
- Generates additional income beyond dividends
- Allows staying invested in stocks you want to keep long-term
With the premiums collected, you lower your breakeven point. This helps offset any decline in the share price.
Risks and Drawbacks to Consider
However, there are some limitations to be aware of:
- Caps your potential upside as you sell off upside rights
- Doesn’t protect against falling share prices
- Requires closely tracking options for adjustments
- Can have tax implications if exercised before one year
You give up participation in any gains above the strike price. So you must choose strike prices carefully based on price targets.
Adjusting and Managing Covered Call Positions
To manage covered call risks and drawbacks, there are a few key strategies:
- Buy back options if you want to capture more upside
- Hedge with protective puts to limit downside
- Only use high quality, stable underlying stocks -frequently roll options forward to collect more premiums
Actively monitoring the options and underlying stock is crucial for maximizing covered call results.
Conclusion
Covered call writing requires some research and active management. But it can help conservative investors earn extra income while holding stocks long-term. Just be sure to learn about options risks and mechanics first.
FAQs About Covered Call Writing
What is the ideal strike price for covered calls?
The ideal strike price is slightly above the current market price – enough to collect solid premiums but low enough where the calls have a good chance of expiring OTM. Around 5-10% above market price is a good target.
What happens if the covered calls get exercised early?
If the options are exercised before expiration, you must sell your shares at the strike price, even if the market price is higher. Be prepared to either buy back the calls or sell the stock.
Should covered calls be used with stocks you want to keep long-term?
Yes, covered calls work well for long-term stock holdings you want to keep for dividends and growth. You collect income from premiums as you wait for the share price to rise.
Is covered call writing a bullish or bearish options strategy?
Covered calls are a mildly bullish to neutral strategy. You profit from modest upticks or sideways trading in the short term. Very bearish or bullish outlooks may warrant other options approaches.
Should you use covered calls in an IRA or taxable account?
Using covered calls in a tax-advantaged IRA helps avoid tax headaches from option exercises or short-term capital gains. Ideally use them in a Roth IRA where premiums and gains aren’t taxed.
