In this article we go into covered calls–a common way to generate income with call options while protecting your assets.
Covered Calls
Definitions
- Call Option:
“When you buy a call, you pay the option premium in exchange for the right to buy shares at a fixed price (strike price) on or before a certain date (expiration date)."
reference - https://www.investopedia.com/trading/beginners-guide-to-call-buying/
- Covered Calls:
“An investor holding a long position in an asset writes (sells) call options on that same asset to generate an income stream."
reference - https://www.investopedia.com/terms/c/coveredcall.asp
Introduction
Selling covered calls can earn extra passive income on stocks that you were planning to hold anyway while providing some downside protection.
You set the strike price at a point that’s reasonable for you to sell at and make profit in addition to the profit from the premium.
The mechanics of a written option:
You pick an expiration date and a strike price.
You collateralize either stock (for calls) or cash (for puts) and get paid a premium for doing so.
If on the expiration date, the stock price is in the money (above call strike price or below put strike price) you will forfeit your collateral.
Is this a bad thing?
Ideally not because when you pick the strike price, you are picking the price you’re comfortable buying or selling at. You’re accepting the risk of giving up your shares if the price moves too much and are getting paid to take that risk.
And if the strike price doesn’t get hit?
Then the options you sold expire worthless and you collected premium for a worthless option.
Doing that over and over again will earn you more and more premium and effectively lower the total cost basis you paid for the whole position.
What happens if the stock goes down?
If you don’t sell covered calls then you lose 1:1 for every dollar that underlying stock drops. If you sell a covered call and earn that money, your cost basis is essentially lowered which gives you extra downside protection.
There tends to be larger downside protection for in the money options but at the trade off of less premium earned (Options at the money pay the most premium).
What if you change your outlook?
Sometimes you still don’t want to be forced to sell (for example if you thought it would go up by like 1% and it went up by 10%). In this situation you can buy the written option back and roll it out to a later date and/or roll it to a different strike price that you’re now comfortable selling at second time around.
Fidelity’s guide:
It’s also a good way to close a position with defined profits when Implied Volatility (IV) drops allowing you to buy back the position for less than you were paid earning a net profit.
Some people prefer to do this rather than waiting the full time for option expiration so they can lock in profits and remove the risks mentioned before.
Now there’s also some tricky factors associated with covered calls and tax implications as well:
Covered calls/puts sold In the Money or with less than 30 days to expiration will automatically result in the holding period ending at the expiration date for the option.
The vast majority of the time this results in a holding period of less than one year meaning the gains will be subject to short term capital gains rates instead of long term rates.
Avoid this by performing this strategy in a tax advantaged account like a Roth IRA or by selling options only OTM and >30 days to expiration.
In addition you want to consider the implications of US style options vs European style options:
US options can be exercised at any time as long as they are In the Money by 1 penny.
Why does this matter if you’re planning on collecting premium etc anyway and agreed to the strike price?
Because often when selling options against dividend paying stocks, the people buying your option has an opportunity presented them. They have to decide between exercising the option you sold to take your stock or waiting for a better price later.
If the holding period happens to coincide with the Ex-Div date then you will find it more likely for the options to be executed if they are close to the money and especially if the price of the option is less than the dividend payout.
In these situations you might find yourself holding shares of a stock you sold options against expecting to earn option premium and dividend payout only to find your stocks gone in the morning and the dividends lost.
Summary
Covered Calls are a common way to generate income with call options while protecting your assets. Compared to other strategies, they are considered to be one of the more conservative approaches to generating income through options.
