What is a Covered Call and How Does It Work?

Options can seem intimidating, but in truth they aren’t that complex. Option trading brings up images of Wolf of Wall St. types, pure degenerate gamblers, or dumb money reading about the latest short squeeze on reddit and piling into a trade.

However, there is a methodical way to apply option strategies in your portfolio that can actually make you extra money while helping to control risks. Covered calls is one of the methods.

Quick Summary:

• Introduce the option strategy of ‘covered calls’ and how they can help you squeeze extra cashflow from your positions

• Logical fallacies are one of the biggest drivers of underperformance and you can get paid to control them

• The trade-off of using covered calls

How to Use Options to Improve Your Returns

This post assumes you have familiarity to the basics of options. At some future point I can do an introduction to calls and puts for you, but that is not the purpose of this article.

Let’s get this out of the way upfront, stock options are slightly more complicated than regular stock trades and you can take very big risks on with them. However, they don’t have to be rocket science and when used correctly, they can do wonders for improving your return profile while even lowering some of the risk you take on.

What Are Covered Calls?

Covered calls are when you sell a call while owning the underlying stock. The combined position is a covered call.

When most people think of options they only think of being the option buyer. Option buyers pay a premium for a potential payoff or 0. However, you can take the other side of the option trade and be the option seller.

Calls give the owner the right to purchase the underlying stock at a given price (strike price) and at a certain date. In order to get this option, the call buyer needs to pay a premium to the seller.

Therefore when we sell a call, we are collecting the premium with the promise to deliver shares at a given price and date in the future. Since we own the underlying stock, we are limiting our risk in the position.

When the maturity date comes, there are 2 possible scenarios:

• The price of the stock < strike price

  • The option expires worthless and no further action

• The price of the stock > strike price

  • The option is executed, and you automatically sell your shares at the strike price

In both cases, you received the premium upfront already. Obviously, the ‘risk’ here is that you buy a stock, sell a call, and the stock moons on you. You sold away all the upside for a small premium. You are trading away the future potential upside for a money today with covered calls.

Covered Calls Example:

You buy 100 shares of XYZ at $4.50 and sell one call option with a $5.00 strike and 1 month to maturity at a price of $0.25. Remember 1 option contract is for 100 shares of stock, so when you sell a call for $0.25, you get $25.00 immediately.

Your position today is worth $475 total ($450 in stock and $25 in collected premium from selling the call). In 1 month if the price of the stock is over $5 your broker will sell 100 shares at $5 for you.

We can look at a few sample outcomes from the position. If we assume the stock price at maturity will be down to $3, flat at $4.50, increase to $6, or increase a lot to $20, our net ending position is shown.

Note - this ignores costs, taxes, and interest/return earned on the option premium. Since you got the option premium on 1/15/2022, you could invest that $25 for a month earning a return.

Comparing the “Stock Position 2/15/2022” vs “Net Position” is the difference between just buying and holding the stock vs using a covered call.

Covered Call Takeaways

From the simplified example above, you can see that you are $25 better off using covered calls as long as the stock stays below $5.25. If the stock ends up over $5.25, you would be better off just holding the stock for the month.

You have capped your max end of month position at $525 in this example, no matter how high the stock price goes. However, you still own the downside, but you can always unwind your position if bad news comes and you want out of the position.

So why keep the downside and give up your upside?

First, if you own a stock you think is going to go up substantially, then covered calls are not a good strategy to use. If there is significant upside, you want to be exposed to it.

Second, most stocks I buy & own don’t immediately go way up in price, so the ‘very high’ scenario above doesn’t happen often. Not to mention there are many ways to use covered calls without giving up all your upside. For instance, you could buy a further out of the money call or even simpler, just own more than 100 shares of the stock, so only part of your position gets called away.

Third, you can get a steady stream of monthly income doing this. It can juice a dividend paying stocks cash flow or turn a non dividend stock into a synthetic dividend paying stock as you pocket the premiums.

What Are The Optimal Times to Use Covered Calls?

Selling a call is essentially being short a position on the stock. Therefore, you don’t expect the price to rise more than the strike + premium. ($5.25 in the example above).

The optimal times to take this position is when a stock has:

• Increased up to your target fair value

• Has a big jump on news that you think is likely overdone

• Is a sleepy blue-chip dividend payer that you want to squeeze a little extra yield out of

Additionally, I really like 1 month calls for this strategy as they have relatively high theta decay and it is a short enough time frame that you can be nimble as the option expires soon.

A good example is if you brought a stock at $2, think its worth $5 and it is currently at $4.50. You could set a sell limit order for $5 and wait. Or, you could sell $5 call options every month until it gets called away. Both result in you exiting at $5, but using options you pocket some monthly premiums along the way.

When a stock jumps in price overnight, the implied volatility in the option prices will be high and this is a good time to potential sell a out-of-the-money call at a high premium. High implied volatility in the stock can be ripe for finding some juicy premiums selling calls.

[Note: The “greeks” of options are outside the scope of this post. But to quickly describe the 2 used here for people unfamiliar with them:

• Theta = measure of the change in price of the option for a change in time. When an option is out-of-the-money, the price goes to zero much faster when you have less time to maturity. Faster theta decay is good for you the option seller.

• Vega = measure of change in price of option for change in volatility. Although outside of academia and actual option traders/hedgers, I have rarely seen the term vega used. Usually it is just called volatility and the more volatile the underlying stock is, the higher the price of the option. ]

Lastly, if I have a boring blue-chip dividend payer, you can sell low premium calls to get an extra $5-10 per month for every 100 shares you own. Even if the stock gets called away, it likely isn’t going to see price increase a lot, so this is a nice way to supplement the dividend.

[Note: Selling calls during the dividend period usually leads to adjustments in the price of the call. Explaining that is outside the scope of this post, but want to call it out in case you see it. For example, you may see your $5 call listed as a “$4.85adj” or something similar due to a $0.15 dividend being paid while the call is outstanding. It is similar to how a stock will open at a dividend adjusted price the trading the day after the ex-dividend date.]

Behavioral Finance, Logical Fallacies, and Covered Calls

The inability to stick to rules is actually one of the main reasons I like to use covered calls. I found myself setting a fair value for a stock, but then when the stock reached that price, rationalizing why it would continue going up and not selling. Most of the time it would go back down and I would regret it.

Therefore, I started setting limit sell orders at my target price. I had to remove any future emotions from it. If the stock was trading at $2, but I thought it was worth $3, I would buy it at $2 and immediately set a sell order for a $3 limit. Many of these orders would sit out there for months and months doing nothing.

Even worse, as the stock started moving up, I would cancel these sell orders and bump them…$3.25…$3.50…because after months of nothing, I wanted a higher return on the position.

Now I largely use covered calls in place of these limit orders and get paid for doing essentially the same thing.

Knowing I am getting money for my sell order, and knowing it cost money to “buy to close” the option, keeps me sticking to my plan. Removing a large amount of my own behavioral fallacies has been a big help for my portfolio.

Wrapping Up: Introduction to Covered Calls

This is an introduction to covered calls. Honestly, this is likely one of the least risky ways to get comfortable with options. Since you own the underlying stock already, presumably you like the company enough to hold it. And since you are holding the stock anyway, you can “sell to open” a call position and gain some cashflow while holding the stock.

If you sell calls on 1/4 of your portfolio a month that are a 4% premium (ie- $20 premium on 100 shares of $5.00), you potentially boosted your annual return by 12%. This is particularly helpful in flat or down years in the market as that is when these calls are never assigned and even though the underlying is going down, your are offsetting some of it with the options.

Last point, some stocks have very little option activity so the bid-ask spread can be large. Most exchanges show the mid-price, but the actual bid & ask can be large (like $0.05 vs $0.45, shown as $0.25). I would recommend to ALWAYS use limit orders on your options otherwise that $25 premium you think you can get ends up being $5 when your market order goes through.

PS - Do not sell uncovered calls or use margin unless you really know what you are doing - that is where you can get you blown up. My main broker is fidelity and you can qualify for level 2 option trading where you can’t use margin or be uncovered. Some brokers you need to call to make sure you don’t have margin turned on.

Continue Reading On Options:

Part 1 - Buying a Call

Part 2 - Buying a Put

Part 3 - Selling a Call

Part 4 - Selling a Put

Cash-Secured Put Strategy