Covered Call Writing

When the market is bullish or trading in a small range, covered call writing is a good technique.

Covered call option plays include selling out-of-the-money call options on an existing stock position. A stake in the underlying stock is used to offset the risk of these short calls being exercised when the stock rises in price. If the stock price drops, the call writer will only lose money on the stock itself, not on the short calls.

Covered Calls as a Strategic Investment

One covered call option contract can be written for every 100 shares of stock owned. The idea is to capitalize on existing positions by collecting option premiums in order to increase earnings. The value of the underlying shares could fall below the option premium paid before the option expires, which would be a loss for the covered call writer. If the stock’s option price closes higher than the covered call’s strike price, the stock will be called, and the investor will not be exposed to the call option’s upside risk.

The buyer of a covered call obtains any and all appreciation in the underlying stock, while the writer of a call receives simply the price paid for his or her shares. A covered call writer can collect profits if his or her option contract is sold before the corresponding short call becomes in the money.

Whether or not the covered call options expire in the money, the writer is entitled to keep the premium received. The option writer can profit by purchasing the short-covered call options and then writing a new call on the stock before the options expire. If the underlying stock price doesn’t drop by more than the call option’s strike price, then the option seller will profit from the daily theta decay.

Protection against a drop in the value of the underlying stock is provided by a covered call option, whose premium decreases as it moves further out of the money in reaction to a drop in the stock price. A covered call writer often seeks to sell a call option with a strike price above the market price of the underlying stock, in the expectation that the stock’s price will remain below that level until the option’s expiration.

By selling a call option on a stock you already own and collecting the premium before the option expires worthless, you can profit from the tactic known as “covered calls.” This paves the way for the writing of several calls on the same stock, each of which can provide a premium sufficient to offset the cost of the stock and produce income.

To add, covered call options can be utilized to sell stock at a predetermined price. In exchange for the premium received, a covered call writer agrees to sell the stock at the option’s strike price if and when the stock price hits the covered call writer’s goal.

Stocks with little fundamental and technical volatility provide the greatest risk when writing covered calls. When stock market volatility is minimal, investors face less danger when hanging onto their investments. Most of the risk associated with covered calls is in the underlying stock. We recommend using option chains with deep liquidity and tight bid/ask spreads. It may be wise to repurchase a covered call option when its value has declined sufficiently and the risk-to-reward ratio no longer favors further decline in the premium. The goal of a covered call option trade is typically to generate income from stock that the investor plans to keep.

Is there any chance of losing money when using a covered call?

A loss will occur in the covered call option strategy if the stock price falls before expiration below the price of the short call option. For this reason, you would likely lose money on the play. Selling a call option, on the other hand, can bring in significantly more money. Because the stock is being utilized to hedge the risk of the short-call option, the stock itself represents the more precarious portion of the options deal. Even if the covered call expires deep in the money and some capital gains on the stock are lost and the shares are also called away, there is a chance of making a net profit on the call option price.

What is the maximum time horizon for selling covered calls?

When call options are sold further out, the buyer receives more time value, but the option’s value decreases more slowly because it has more time to go in the money.

Between 30 and 45 days out from expiry is optimal for selling covered calls to maximize premium and reduce time decay. You need to sell an option contract with a substantial premium for the option play to be profitable. Selling covered calls results in a discount of around 2% off the stock price.