How to Use Covered Calls: A Comprehensive Guide to Generating Income and Managing Risk in Investing

What are Covered Calls?

A covered call is an options trading strategy where an investor sells (or “writes”) a call option on a stock they already own. Here’s how it works:

• Owning the Underlying Stock: You must own at least 100 shares of the underlying stock.

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• Selling a Call Option: You sell a call option on those shares, giving the buyer the right to purchase the stock at a specified price (the strike price) before a certain date (the expiration date).

This strategy is often considered neutral because it is most effective when investors expect minor price movements in the underlying stock. By selling a call option, you are essentially betting that the stock price will not rise significantly above the strike price before expiration.

How to Set Up a Covered Call

Setting up a covered call involves several steps:

1. Own the Underlying Stock: Ensure you have at least 100 shares of the stock in your portfolio.

2. Choose the Strike Price: Select a strike price that aligns with your expectations for the stock’s future performance. If you expect the stock to remain stable or slightly increase, choose an out-of-the-money or at-the-money strike price.

3. Select the Expiration Date: Decide on an expiration date that fits your investment timeline. Common expiration dates include weekly, monthly, or quarterly options.

4. Sell the Call Option: Execute the trade by selling one call option contract for every 100 shares of stock you own.

For example, if you own 100 shares of XYZ Inc. and expect it to remain stable around $50 per share, you might sell a call option with a strike price of $55 and an expiration date in one month.

Benefits of Covered Calls

Using covered calls can offer several benefits:

• Income Generation: Selling call options generates premiums that can be higher than traditional dividend yields. This can provide a regular stream of income from your existing stock holdings.

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  Reduction in Cost Basis: The premium received from selling the call option can lower your overall cost basis for holding the stock. For instance, if you bought XYZ Inc. at $50 and received a $2 premium for selling a call option, your effective cost basis would be $48.

• Downside Protection: The premium acts as a buffer against potential losses if the stock price drops. While it won’t completely offset large declines, it does offer some protection.

Risk Profile of Covered Calls

While covered calls offer several benefits, they also come with some risks:

• Capped Upside Potential: By selling a call option, you limit your potential profit if the stock price rises above the strike price. If XYZ Inc.’s price surges to $60, you would miss out on gains above $55.

• Downside Risk: Even with the premium received, there is still a risk that the stock could drop significantly or even to zero.

• Risk/Reward Chart: Understanding the risk/reward chart is crucial as it visually represents the trade-off between extra income and capped upside potential.

Best Times to Use Covered Calls

Covered calls are particularly effective in certain market conditions and scenarios:

• Flat Markets: When markets are stable or expected to be so, selling covered calls can generate additional income without significant risk.

• Generating Income: Investors seeking regular income can benefit from selling covered calls on stocks they hold long-term.

• Tax-Advantaged Accounts: Using covered calls in tax-advantaged accounts like IRAs can help optimize after-tax returns.

To determine the right strike price, consider the stock’s fair value and your expectations for its future performance.

Managing and Adjusting Covered Calls

Managing your covered call positions is crucial for maximizing returns and minimizing risks:

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  Rolling Down or Up: If the stock price moves significantly, you may need to roll down (sell a lower strike price) or roll up (sell a higher strike price) to adjust your position.

• Hedging Strategies: Purchasing put options or repurchasing call options can help hedge against potential losses or lock in profits.

For example, if XYZ Inc.’s price drops below your strike price, you might roll down to a lower strike price to continue generating income while adjusting to the new market conditions.

Example Scenarios

Let’s look at three different scenarios at expiration:

1. Stock Price Below Strike Price: If XYZ Inc.’s price is below $55 at expiration, the call option will expire worthless, and you keep the premium as profit.

2. Stock Price at Strike Price: If XYZ Inc.’s price is exactly at $55 at expiration, the call option will likely expire worthless as well, allowing you to retain the premium.

3. Stock Price Above Strike Price: If XYZ Inc.’s price is above $55 at expiration, your shares will be called away at $55, capping your upside potential but ensuring you receive the strike price plus any premiums collected.

Calculating profit and loss in each scenario helps illustrate how this strategy works in real-world conditions.

Additional Resources

For further reading on covered calls and options trading:

• Investopedia: Covered Call

• CBOE: Options Trading

• SEC: Options Trading

These resources provide additional insights into options trading strategies and best practices for managing risk.

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