How Do Covered Calls Work?

 

You may have heard that selling covered calls can increase earnings from stocks.  

How do covered calls work exactly? Covered call writing is a strategy where a stock investor sells call options that give the call option buyer the right to buy the stock from the stock investor at a set price and within a certain time.  

Covered calls are used to generate income that is much higher than dividends from stocksThey are often compared to “collecting rent” on stocks, similar to real estate rental investing. 

It’s important to note that covered calls have slightly lower risk as investing in stocks without selling covered calls. After selling covered calls over the past 13 years and investing for almost 40 years, I have grown fond of covered calls for this very reason.   

Risk from Covered Calls 

At my age, I like low investment risk and I like to address risk management at Retire Certain.   

Even though covered calls have slightly lower risk than stocks without covered calls, the stock market is subject to bear markets every decade or two.  

You can read more about this in my article How Will a Stock market Crash Affect You 

How Do Covered Calls Work?  

The best way to see exactly how covered calls work with is with an example.  

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 (option expiration) 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.   

Read my related post Are Covered calls a Good Strategy? 

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 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.   

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 monthor 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 expiration day is below the strike price. 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. Interestingly, most investors think covered calls are risky since they involve selling options.   

Here is my Covered Calls for Income post about a covered call I sold that did not get exercised.   

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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.  

Covered Call Return on Investment 

Susie’s 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 savings 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).  

While I would never suggest that this exact same covered call return could be repeated throughout the year, annualizing allows you to see how a dividend stock return compares to a covered call return on investment.  

Read more in my related post on living off covered calls 

Dividend Income Vs. Covered Call Income 

A typical dividend stock pays between 1% and 5% 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 a high as dividend stock returns.   

Read my related post Is Dividend Investing Worth It? 

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 methods.      

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.  

Also, higher perceived risk for a stock or ETF allows covered call investors to generate higher income since the call options have higher premiums from the higher perceived risk.  

When planning for covered call income, I like to use a very conservative 18%.  

Dividend income on the underlying securities can add another 1% to 8% 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 before making any stock investment, including covered calls. 

You can read more about this in my post entitled How to Know If Stocks Will Go Up 

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. Read about the related 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 strategyespecially true for stock investors who are okay with stock market risk anyway.  

Since basic covered call strategies don’t work well in bear markets, we learned it’s important to diversified income producing assets that work in different economies and market environments.   

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, which you can probably appreciate love as much as I do.   

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 all types of ETF’s, investors can increase income while slightly lowering investment risk.       

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Disclaimer: Nothing in this post is meant to be taken as personal financial advice. You are responsible for your money.

 

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