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Options Strategy: Selling Covered Calls

Posted on March 11, 2009 by Adam

Whether you are a long term investor, a trend trader, or a swing trader, selling covered calls can help make your trading more profitable.

A covered call sounds more complicated than it is. If you own stock, a covered call is as simple as selling a call on the stock that you own. This strategy can act as a source of income for a stock that is moving sideways or even down. Here’s how it works.

When you sell, or write, a call option, you are agreeing to sell 100 shares of the underlying stock to the buyer of the option at the strike price on or before the expiration date of the option. As a seller, you receive a payment from the buyer up front for the right to buy your stock. If that option expires in the money, then you may have to sell your stock to the buyer of the option, but you still get to keep the premium. However, if the option expires out of the money, the option will probably not be exercised, since the stock is cheaper on the open market. In that case, you keep your stock and the premium.

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Let’s say you are long 100 shares of (AAPL: 258.11 -1.09%). Let’s say that your cost basis is $85, but over that last few months the stock has been moving sideways, generating little profit, if any. In order to make some income on the stock you own, you could sell a covered call on the stock.

An option chain showing the March calls for AAPL.

A call option is nothing more than an agreement between the buyer and the seller. The buyer of the call option has the right, but not obligation, to buy shares of the underlying stock from the seller at an agreed price on or before the option’s expiration date. The agreed price is called the strike price. For more on options basics, see my Options Cheat Sheet.

If the option expires when the stock is trading higher than the strike price of the option, then the option buyer can buy the stock at a discount. In that case, we would say the call option is “In the Money.” In that scenario, the option buyer would most likely exercise his or her option to purchase the stock at a discount. If the option were to expire when the stock was trading at a lower price than the strike price of the option, then the call option offers no discount. That would be an “Out of the Money” option. Most option owners won’t exercise out of the money options, since they could just buy the stock cheaper on the open market. That option expires worthless.

If we want to enter a covered call trade, we want to sell a call option. In essence, we are short a call option. However, you wouldn’t want to sell a call option on a stock you don’t own - that would be a naked call position - one with unlimited risk. When you sell a call against a stock you own, if the option expires in the money, you have the stock on hand to sell if necessary. You are “covered”. Hence the name covered call. In that case, the most you can lose is capped by the strike price of the option.

Let’s go back to our example. We are long AAPL with a cost basis of 85. We are confident we want to hold the stock, so we sell an out of the money call, knowing that it will most likely expire out of the money.

The stock is currently trading at about $93, so we decide to write a 100 call. We own 100 shares, so we sell one call, which represents 100 shares. When we sell the call, we collect the 66 cent premium, offsetting our cost basis by 66 cents. Our cost basis is now $84.34.

There are two possible outcomes to the trade, depending on how the stock moves. The option expires in 9 days. If, after 9 days, the stock is trading below $100, then the option expires out of the money. Let’s say the option expires when the stock is trading at $95. Since the stock is trading for less than 100, the option buyer will not exercise his or her option to buy, and we keep our shares and the premium the buyer payed for the option. Our total profit so far is 95 - 84.34, or $10.66 per share, which is almost 7% greater than what we would have made without selling the call.

Now let’s say that the stock is trading above 100 when the option expires - at 105. Since the option allows its buyer to purchase our shares at 100, which is less than 105, he or she will most likely exercise the option. In that case, we will be obligated to sell the shares at a $5 discount as opposed to the open market. However, we will still keep the $0.66 premium payed by the buyer. Our total profit is 100 - 84.34 or $15.66 per share, which is 22% less than what we could have received had we not sold the call.

As you can see, selling covered calls is not the perfect solution to all your problems. You still have to be right that the option will be out of the money on expiration, but if you are right, selling a covered call can lower your cost basis and help you make the most out of a stock that is underperforming your expectations.

Happy Trading!

Adam