Are Covered Calls a Good Strategy?

retirement nestegg | Are covered calls a good strategyIn 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? Selling covered calls increases income significantly while decreasing risk making them an excellent income strategy for stock investors. 

In fact, you can add .5% to over 3% income per month that goes right into your brokerage account as soon as you sell the call option against your existing stock holdings.

This sounds pretty good to income investors! But there’s more to know that I wish I had known before I began selling covered calls over 13 years ago which most covered call courses fail to mention.

In this post I’ll explain when covered calls are a good strategy and when they don’t work after selling hundreds of covered calls in both bull and bear markets.

Covered Calls Are 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.

While covered calls are an excellent way to significantly increase income from stocks, they can also be structured to capture capital gains as covered more below.

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

Capital Gains Vs Income

Many investors think covered calls are not a good strategy because they can rob investors of capital gains. This can be true, especially for investors whose main objective is high capital gains from owning fast growing companies.

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 Call Options

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.

Assuming 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.

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

On the other hand, if Income Inc goes to $110 a share, the covered call investor has 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 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.

Dividends get 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 ready 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 options premiums. And what seller of anything doesn’t want to get a higher price for what they are selling?

These 3 advantages make selling covered calls a good strategy even for investors with a capital gain objective. The added income from selling covered calls is icing on the cake.

How to Get More Capital Gains from Covered Calls

Investors wanting to make capital gains as a 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 if the option gets exercised.

In this case, the call option premium would be lower since the further away you move from the stock price the lower the option premium is.

With covered call strategies, there is always 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 to Get More Income 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.

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

In this case, the investor keeps the $300 from selling a call option.

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

If Income Inc is at $99 at option expiration, 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 call had not been sold.

Here’s my related post on living off investments.

Are Covered Calls Safe?

The question is not really are covered calls safe, but are stocks safe? And this goes back to your wealth plan (which defines your acceptable risk) and overall stock market valuations. Read my related post How Will a Stock Market Crash Affect You? 

This is because overvalued markets relative to history are have more risk. Undervalued markets relative to history are safer.

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 reduced by the covered calls sold against it.

In the case of Income Inc, 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 will significantly lower their cost over time.

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

When Does a Covered Call Strategy Work?

Covered call strategies work best in sideways or bull markets. It’s a beautiful thing to sell high premium out of the money call options in the 3% to 5% range on up trending high growth stocks that get called away every month or two.

It’s easy and highly profitable.

This was the environment when I learned to sell covered calls and I was hooked. Then the bear market began in 2007.

Here’s a video on selling covered calls for income in the start of the 2009 bull market with a diversified ETF portfolio, but keep reading about selling covered calls in bear markets. Yikes!

 

When Does a Covered Call Strategy Not Work?

Speaking of bear markets, I can write first hand that a 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. If the investor sold a call option with a $95 strike and it got exercised, there would be a loss of $5.

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.

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

Even so, managing a few covered calls takes a few hours a month making it well worth the effort.

Investment Capital for Covered Calls

One problem arise when covered call investors have all their capital invested in stocks that have fallen. When this happens selling covered calls is harder and the income generated is reduced.

This is why income diversification can be as important as investment diversification. Read more about this in my post entitled How Many Income Streams Should You Have? 

Speaking from experience, it’s a relief to be able to sell covered calls as opportunities present themselves knowing that other types of income streams will still be there.

This is one reason I like selling covered calls on dividend stocks.

Note that selling covered calls on short stock index ETFs can work well in bear markets for advanced investors.

In Summary, Are Covered Calls a Good Strategy?

Covered calls are 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 bonds yields are very low.

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