You may have heard that selling covered calls can increase earnings from stocks.
Here’s how covered calls work. A stock investor sells call options that give the call option buyer the right to buy the stock from the investor at the option strike price on or before the option expiration date. The option buyer will exercise the right to purchase the stock if the stock’s market price is above the option strike price.
Covered calls are a good strategy to generate income that is much higher than dividends from stocks. They are often compared to “collecting rent” on stocks, similar to real estate rental investing.
Some of my financial coaching clients ask how covered calls work, particularly older investors with large stock positions and low dividend yields.
While I’m an AFC (Accredited Financial Counselor), I learned how covered calls work from selling many over the past 15 years.
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Risk from Covered Calls
Here at Retire Certain, I like to address investment risk and risk management first since not losing money is as important as making money.
Note that covered calls have slightly lower risk than investing in stocks without selling covered calls because they reduce the investor’s basis, contrary to what many investors believe.
The real risk of covered calls is the underlying stock’s value declining due to bear markets or other factors.
How Do Covered Calls Work?
The best way to see exactly how covered calls work is with an example of an in the money, at the money, and out of the money covered call.
Susie bought 400 shares of Income Corp for $29.50 a share on March 10. She really wanted to generate some income from the stock, but the dividend yield was only 1% a year.
She decided to sell 4 April call options with a strike price of $30 for $ .50 per contract.
This gave the call option purchaser the right to buy her stock FROM her at $30 on the third Friday of the month in April, or April 21 that particular year.
While it may seem like Susie would only get $2 from the sale of the call options, she gets $200 since 1 option contract equals 100 shares of stock.
The $200 comes from the following calculation:
$.50 per option contract x 4 contracts x 100 = $200
Susie immediately gets a debit of $200 in her brokerage account for the sale of the option.
Note that commissions would be deducted from her proceeds first, but since commissions vary greatly among brokerage firms, I will exclude commissions in this example and related calculations.
Commissions and potential taxes based on your own situation should always be factored into any investment evaluation.
How Do Covered Calls Work at Option Expiration?
Understanding what happens at options expiration is based on the covered call strategy that was used.
When the strike price is higher than the stock’s cost, it’s called an out of the money covered call.
Susie’s cost was $29.50 and the option strike price was $30.
In this example, Susie sold an out of the money covered call, as opposed to an at the money or an in the money covered call.
This is very important to note here because whether a covered call is in the money, at the money or out of the money affects how covered calls work at option expiration as explained later in this post.
Don’t be confused by the 3 different covered call strategies. Each strategy is slightly different, but the overall covered call structure is very similar.
On the option expiration date, the third Friday of the month, or April 21 that year, one of 3 things can happen:
Income Corp Closes at the Option Strike Price
Let’s say Income Corp closes at exactly $30. The option buyer may or may not “exercise” the option, or buy the shares, since the option strike price is the same as the market price on option expiration.
Either way, Susie gets to keep the $200 from the option sale so Susie is happy with this outcome which she evaluated before she made the covered call investment.
Income Corp Closes Below the Option Strike Price
Assume Income Corp closes at $29.
The option buyer doesn’t exercise the option since the market price of the stock on the expiration day is below the strike price. This is logical; if he wants the stock, he can just buy it in the stock market for $29 so it wouldn’t make sense for him to buy it for his option strike price of $29.50.
His option expires worthless. This is often the case, which is a huge advantage for option sellers, or covered call investors.
It’s unfortunate that the stock price dropped because now Susie has a loss in the stock if she sells it at $29 since Susie bought it at $29.50.
(She will have an unrealized loss if she does not sell it.)
Susie was going to buy the stock anyway so she would have experienced the same loss even if she had not sold the covered call.
And she gets to keep the $200 for selling the option anyway, which reduces her Income Corp position cost per share to $29.00. This means that she is now at break-even on her stock investment even though the stock dropped in price.
This is what makes selling covered calls slightly less risky than simple stock investing: covered call income lowers the cost of stocks.
The best place to start is with my Ultimate Wealth Plan. You can get it here now.
Income Corp Closes Above the Option Strike Price
In this third and last scenario, Income Corp closes at $30.50. The option buyer will exercise his right to BUY the shares at the strike price of $30, since the market price is now more than the strike price.
While Susie must sell at $30, which is below the market price of $30.50, she is happy with this outcome.
When she evaluated the covered call trade before making it, she had no way of knowing for sure if the stock would increase in value, but the option income was a sure thing.
And even though she gave up some of the stock increase, she still makes $1.00 per share on the overall position as follows:
Sales Price of Income Corp $30.00
Less Cost of Income Corp – $29.50
Profit from Sale of Income Corp .50
Plus Income from Selling Call Option .50
Total Profit per Share $1.00
Total Covered Call Profit = $ 1.00 x 400 Shares = $400
A profit of $400 is not too bad for a stock that dropped in value.
Rolling covered calls, however, can prevent Susie from having to sell the covered call due to exercise. This is a slightly more advanced covered call technique.
Covered Call Return on Investment
Assuming Susie doesn’t roll the covered call, her return is 3.45%, calculated as follows:
Profit/Investment Capital x Number of Shares
($400/$11,600 x 400 shares)
Susie’s investment capital is calculated like this:
Cost of Stock – Call Option Income
$29.5 – $.50 = $29 x 400 = $11,600
Annualizing Covered Call Income
Since this covered call was exercised, Susie’s investment capital was tied up in this trade for only 42 days, so we can logically annualize this return.
Doing so equates to an approximate 30% return a year before commissions and potential taxes.
The formula to annualize covered call return is .0345/.115 (42 days/365 days).
Even though this exact same covered call return certainly isn’t guaranteed throughout the year, annualizing allows you to see how a dividend stock return compares to a covered call return on investment since dividends are typically given on an annual basis. This provides an important comparison for someone living off covered calls.
Dividend Income Vs. Covered Call Income
A typical dividend stock pays between 1% and 3% as of this writing. Compare this to a 30% annual return from selling covered calls.
While covered calls do some time to implement, it’s not a lot of work.
And the remarkably higher income is made without taking any more risk than outright stock investing, something almost all investors do already anyway.
While higher risk stocks pay higher dividends, with covered calls, higher risk stocks don’t have to be purchased to get returns two to twenty times as high as dividend stock returns.
When comparing covered calls returns to dividend yields, an investor has to wonder: Is Dividend Investing Worth It? Selling covered calls on dividends can result in both dividends as well as call option income, however.
Average Return Selling Covered Calls
At this point, you’re probably wondering if 3.45% is a typical covered call return. The average return selling covered calls is impossible to say since every covered call investor will choose different securities and covered call strategies.
A covered call writer can sell call options at higher premiums when the markets are more volatile and feel less certain. This is because option pricing is a function of market volatility, or IV (implied volatility).
The higher perceived risk for a stock or ETF allows covered call investors to generate higher investment income since the call options have higher premiums from the higher implied volatility.
When estimating investment income from covered calls during my planning and capital allocation, I like to use a very conservative 18% annual return.
Dividend income on the underlying securities can add another 1% to 6% or higher based on the timing and the perceived risk of the security.
Covered Calls Work Best in Bull Markets
It’s important to assess overall stock market risk as explained in my post How to Know If Stocks Will Go Up before making any stock investment, including those for selling covered calls.
As you can see from the covered call example above, covered calls work best in sideways or rising stock markets. This is because they either get exercised every month or you can sell another call option with a strike near your cost in sideways or rising stock markets.
I learned this firsthand, which is mostly what I write about here at Retire Certain.
When I began selling covered calls in 2006, for example, I consistently had a very high return on investment. I was amazed that everyone wasn’t selling covered calls. Then the bear market of late 2007 made it hard to sell call options near my cost as explained in my article problems with covered calls.
The good thing is that the stock market is rising much more often than it is falling based on long term trends making covered calls an excellent income strategy, especially true for stock investors who are okay with stock market risk anyway.
I am still amazed that more stock investors don’t sell covered calls given the high income, but I think it is due to lack of understanding.
Wealth Managers and Covered Calls
While some wealth managers sell covered calls for high net worth clients, there are not many that do since it is a lot of work to do so for hundreds of clients. Passive dividend investing based on an asset allocation is much easier for wealth managers and is the accepted method.
Many stock funds sell covered calls. The return is much lower through funds than it is for individual investors due to the high volume of call options that must be sold in funds due to their size.
This gives individual stock investors who sell covered calls a rare inside edge over financial institutions, which you can probably appreciate as much as I do as a fellow individual investor.
Covered Calls on Stocks Vs ETFs
Covered calls work for both stocks and ETFs of all types, including real estate, gold, and commodities.
One of my favorite covered call strategies was selling slightly in the money covered calls on an ETF portfolio with bonds and other defensive investments for an older family member who needed investment income with low risk.
I placed stop losses at her ETF cost after reducing the cost for covered call income.
Summary for How Covered Calls Work
In this post you’ve seen how covered calls work. By adding covered calls to a portfolio of individual stocks or ETF’s, investors can increase income while slightly lowering investment risk.
The best place to start is with my Ultimate Wealth Plan. You can get it here now.
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