Are Covered Calls a Good Strategy?

retirement nestegg | Are covered calls a good strategy

In this time of low dividend yields, increasing stock income by selling call options on stocks you already own sounds pretty appealing to yield hungry investors.

Are covered calls a good strategy? Covered calls can be an excellent income strategy for stock investors willing to forego capital gains above the strike price should the call options get exercised. 

The income from selling the call option goes right into your brokerage account as soon as you sell the option against your existing stock holdings.

This can make covered call income an excellent extra income source for stock investors. There’s more to know, however, that I wish I had known before I began selling covered calls over 14 years ago.

Should you decide covered calls are a good strategy for you, be careful. It’s easy to get attracted to the high yields generated from selling covered calls. Many of the covered call courses, however, fail to emphasize the importance of risk and other crucial factors related to covered call strategies.

In this post, I’ll explain when covered calls are a good strategy and when they aren’t after selling hundreds of covered calls in both bull and bear markets. This will allow you to assess if covered calls are a good strategy for you personally in reaching your own financial goals. 

Covered Calls Can Be a Good Strategy IF They Meet Your Investing Goals

Everything with investing circles back to your overall wealth plan which clarifies your investing goals. Investing goals generally fall into one of three objectives; capital gains, income, or both.

One of the best things about covered calls is that they can bring multiple benefits. While covered calls are an excellent way to significantly increase income from stocks, they can also be structured to capture capital gains, too, as covered more below.

(Read my related post How to Create a Wealth Plan here. )

 

Capital Gains Vs Income from Covered Calls

Many investors think covered calls are not a good strategy because they can rob investors of capital gains. This is often true, especially for investors whose main objective is high capital gains from stocks through rapidly increasing stock prices.

While selling covered calls may not be a good strategy for such an investor, there are three considerations that may make covered calls more appealing, even for growth oriented investors.

1. Selling Out of the Money Covered Calls

When an investor sells out of the money call options, at least some of the capital gain potential is kept.

For example, let’s say you buy 100 shares of Income Inc for $100.

Assume the stock price is still $100 when you immediately sell a call option with a $105 strike price for $2 a contract.

This is known as an out of the money covered call strategy since the option strike price is higher than the cost of the stock.

If the stock goes to over $105 at option expiration, the option will be exercised, forcing you to sell the stock. You’ll still get to keep $5 of the capital gain, however, when the option gets exercised.

On the other hand, if Income Inc goes to $110 a share, while the covered call writer gets to keep $5 of the capital gain, he has also missed $5 of the capital gain.

Either way, you got the income from selling a call option for $2, which equates to $200 before commissions on 100 shares.

 

2. Covered Call Income Is a Sure Thing

One of the biggest advantages to covered calls is the certainty with which the income is received. Again, that income goes straight into your brokerage account when the call option is sold.

On the other hand, capital gains are an unknown since we don’t know what a stock’s price will do.

In the above example of Income Inc, the investor doesn’t know if the stock will go to $105 or not.

The $200 (less commissions) will certainly go into the brokerage account when the call option is sold. This is a sure thing.

In the world of stock investing, certainty is rare and good.

For example, dividends are sometimes cut, companies miss earnings, and stock prices move up and down, but the income from selling a covered call goes right into your account.

Click here to read my related post Does Living Off Covered Calls Really Work?

 

3. Option Premiums Are Higher for High Growth Stocks

High growth stocks, in general, have more perceived risk. And more perceived risk means the stock will fluctuate in price a lot. This is known as higher volatility.

Stocks with higher volatility have higher option premiums. What seller of anything doesn’t want to get a higher price for what they are selling?

These 3 advantages can make selling covered calls a good strategy even for investors with a capital gain objective. The covered call writer can still capture at least some of the potential capital gains while the increased income from selling covered calls is the icing on the cake.

 

Are ETF Covered Calls a Good Strategy? 

For investors who like to reduce risk through diversification, selling covered calls on ETFs can be a good way to diversify while generating extra income. ETFs work well for covered call strategies when there is enough volume to keep the bid-ask spread narrow, and when the ETF sector aligns with the investor’s desired asset holdings, such as stocks, bonds or gold, for example.   

 

Out of the Money Covered Calls Get Higher Capital Gains 

Investors wanting to make capital gains the main objective can sell out of the money call options to further increase the capital gains potential.

In the above example of Income Inc, selling a call option with a strike price of $110 would allow the investor to keep $10 of the capital gain, even if the option gets exercised.

In this case, the call option premium would be lower since the further the strike price moves up from the stock price, the lower the option premium is.

The reality is that with covered call strategies, as with most investments, there is a trade-off between income and capital gains. The good thing is that investors can structure the covered call strategy for either more income or more capital gain potential.

Click here to read my related post Covered Calls for Income. 

 

How Much Income Do You Get from Covered Calls?

Investors can sell covered calls with a strike price closer to the current stock price to get more income. In the case of Income Inc, say an investor sold a call option with a strike of $100 for $3 on a stock just purchased for $100.

This is called an at the money option since the strike price is right at the stock purchase price.

In this case, the investor keeps the $300 from selling the call option, or $3 times 100.

Notice that the option income is higher for the at the money call option.

If Income Inc is at $99 at option expiration, for example, the option won’t get exercised and the investor keeps the stock.

If Income Inc is at $105 at option expiration, the covered call seller will miss out on $5 of capital gain he would have had in the stock if the covered call option had not been sold.

Here’s my related post on living off investments.

(Note that potential commissions and taxes are being excluded from the examples.)

Are Covered Calls Safe?

The question is not really are covered calls safe, but are your underlying stocks safe? The answer to this goes back to your wealth plan which defines your acceptable investment risk. Read my related post How Will a Stock Market Crash Affect You? 

Sometimes investors overlook the risk in the stock market since stocks are considered a mandatory investment by many. Bear stock markets are rare but they do happen.

When selling covered calls, it’s important to remember that overvalued markets relative to history have more risk. Undervalued markets relative to history have been safer even though it feels like the opposite is true.

You can read more about this in my post How to Know If the Stock Market Will Go Up or Down.

For stock investors who already accept stock market risk, covered calls do not increase risk. In fact, covered calls lower risk slightly.

This is because the cost of a stock can be offset by the covered call income it has generated.

In the case of Income Inc, for example, the stock cost of $100 could be reduced to $97 if a $3 call option was sold against it. Investors that sell call options several times against the same stock purchase can significantly lower their cost over time.

Click here to read my related post Risks of Income Investing.

When Are Covered Calls a Good Strategy?

Covered call strategies work best in sideways or bull markets. Any investor can appreciate that covered calls are a good strategy when she can sell high premium out of the money call options in the 3% range on up trending stocks which get exercised every month.

This is covered call selling at its finest. It’s easy and highly profitable.

When I learned to sell covered calls, this was the environment, and I was hooked until the bear market began in 2007. As you’ll see below, covered calls are not a good strategy in bear markets.

After the bear market ended in March of 2009, covered calls became a good strategy again.

Here’s a video on selling covered calls for income at the start of a bull market with a diversified ETF portfolio. Selling covered calls in a bear market can have less favorable results, however, so keep reading.

 

 

 

 

Factors to Assess if Covered Calls Are a Good Strategy for Your Investment Goals

Factors Affect
Align with Wealth Plan Life & Financial Goals
Meet Investment Goals Capital Gains Vs Income
Within Acceptable Risk Financial Peace & Funds for Life
Existing Stock Market Risk More Income Without More Risk
Have Other Income Streams Diversified Income During Bear Markets
Sideways or Bull Market Covered Call Strategies Work Best
Don’t Mind Managing Positions Managing Uncalled Positions Takes Time
Willing to Trade Gains for Income Covered Calls Forfeit Potential Gains

 

When Does a Covered Call Strategy Not Work?

Speaking of bear markets, I can write first hand that a basic covered call strategy does not work as easily on down trending stocks.

During bear markets, covered calls can still be sold but they have to be managed more.

Here’s why. In the Income Inc example above, let’s say the stock dropped to $93 at option expiration due to a rare, rapid overall stock market decline. If the investor had sold a call option with a $95 strike and it got exercised, there would be a stock loss of $5. Note that the option income would offset some of the loss.

Note that there are ways to roll covered calls so they don’t get called at a loss. My experience has been that this frequently works but it takes some management. In other words, it’s not as easy to sell covered calls in bear markets as it is in bull markets.

More complex option strategies can be used successfully but it takes more effort than simply selling covered calls against up trending stocks.

More advanced covered call writers sell covered calls against ETF’s that short the stock market. This can work, but it can also be tricky to navigate since so one knows exactly when the stock market will change direction.

Managing a few covered call positions can take a few hours a month, however, making it well worth the effort for many stock investors to get extra income from stocks.

Investment Capital for Covered Calls

Investors pondering if covered calls are a good strategy for their own investment goals will first want to make sure investment capital is well allocated.

A problem can arise when covered call investors have too much capital invested in stocks that fall. When this happens selling covered calls is harder and the income generated is reduced. This creates a problem for stock investors and retirees who have come to depend on covered call income. 

One solution to this is income diversification, which can be as important as investment diversification. Read more about this in my post entitled How Many Income Streams Should You Have? 

For covered call sellers, it’s important to have other types of income streams during the occasional bear markets in which covered call selling is more challenging.

Selling covered calls on dividend stocks can be a good strategy for such times.

 

In Summary, Are Covered Calls a Good Strategy?

Covered calls can be a good strategy for investors who are already invested in stocks anyway. They can provide excellent income without increasing risk at a time when interest rates and bond yields are very low.

The information on this website is for education only and is not to be construed as personal financial advice.