Covered calls can be an excellent income source for stock investors, but it can be confusing to know the best option expiration to choose for the call being sold.
The further out the option expiration, the higher the premium and the longer the stock has to reach the strike price. How far out you should sell covered calls, then, is a factor of how much premium you want to collect, the stock’s trend and speed of movement.
In this post, I’ll expand on these factors to help you decide how far out you should sell covered calls based on your own goals and the attributes of the underlying stocks.
Are Near or Far Covered Calls Better?
To discern if selling near or far covered calls is better for you, begin by reviewing your goals for writing (selling) covered calls.
If your goal is to get the highest option income possible, you’ll probably sell covered calls that are not far out to increase the number of times you can collect option premiums.
On the other hand, if you’re more interested in passive income with less effort and expense, you may prefer covered calls that are far out.
New to covered calls? Read my related post: How Do Covered Calls Work?
What Is Considered a Far Out Covered Call?
Covered calls with an option expiration date within days or a few weeks is considered short term.
On the other hand, covered calls with an option expiration date more than five to six weeks away is considered far out.
Short Term Covered Calls
There are several advantages and disadvantages of short term covered calls. My related post Are Covered Calls a Good Strategy explains this more.
|Near Term Covered Call Pros||Near Term Covered Call Cons|
|Increased Covered Call Volume||Higher Trading Expenses|
|Weekly Options||Loss of Time Value|
|Higher Trading Volume||Higher Taxes|
Advantages of Short Term Covered Calls
Short term bonds have less risk than long term bonds because there’s less time for the unknown to happen the closer the bond maturity date is.
Similarly, short term covered calls have less risk simply because the short term is more predictable than the long term.
In the short term, pricing of the underlying stock used for covered call writing is less likely to be affected by unknowns, such as earnings announcements, dividend payments and random unknowns, like Black Swans and bear markets.
This increased predictability favors covered calls that are near term vs long term.
Ability to Sell More Covered Calls
Short term covered calls allow the call writer to sell more covered calls than a call writer with long term covered calls.
Every time a call option is sold, premium gets deposited to your account, thereby increasing income. This is one time that less is not necessarily more.
In recent years, weekly options have become hugely popular for the reasons stated above. Weekly options allow call writers to sell a short term call four times a month instead of once.
Weekly options give investors selling short term covered calls an additional opportunity that wouldn’t make sense for long term covered call writers.
Higher Trading Volume
Far out options often have lower trading volume than near term options. Lower trading volume results in higher bid ask spreads. This equates to lower profits from covered call writing.
Additionally, it’s harder to trade low volume options.
Read my post Do Covered Calls Really Work? for more on this.
Disadvantages of Short Term Covered Calls
Despite the ability to receive option premiums more often, short term covered calls are definitely more work. There is something nice about the lack of effort selling call options two to three months out.
In addition to the time it takes to sell the call options, accounting and taxes must be done for every time a call option is sold. This adds even more effort to short term covered calls.
Higher Trading Expenses
More call writing also means higher trading costs. Fortunately, this is less of an issue since trading commission competition has become fierce since the advent of online trading.
Loss of Time Value
One of the biggest advantages of covered call writing is the option seller’s ability to take advantage of time decay, as explained more below.
With short term options, however, the call writer loses most or all of this advantage since the option has little if any time decay built into the option pricing when the call is sold.
Read my post Problems with Covered Calls for more on this.
Taxes usually must be paid on the income that gets deposited into your account every time a call option is sold.
Moreover, since covered call writing typically produces short term capital gains, the tax rate on covered call income is usually taxed at a higher rate, adding insult to injury.
Note that covered calls can be sold inside an IRA to alleviate this problem.
Far Out Covered Calls
Long term or far out covered calls have their own advantages and disadvantages.
|Far Out Covered Call Pros||Far Out Covered Call Advantages|
|Passive Income||Higher Spreads|
|Higher Call Option Premiums||Less Covered Call Writing|
|Lower Trading Fees & Taxes||Higher Risk|
|Earnings & Dividends|
Advantages of Long Term Covered Calls
Call options can be sold two to six months out creating passive income that requires minimal effort.
Higher Call Option Premiums
The longer the time frame, the more income you get when selling a call option, due to the time factor built into the option pricing.
This higher premium also makes covered call writing more passive, since it can result in less time to reach your goals.
Lower Expenses and Taxes
With covered calls that are far out, just the opposite is true of the expenses and taxes addressed under short term options section.
Selling far out covered calls results in fewer covered call positions sold, which lowers both trading expenses and taxes.
Factors Increase Far Out Call Premiums
While less predictability can be a risk in covered call selling, the flip side of that coin is higher income. Longer term options often cover a time frame when earnings, dividends or both occur.
The higher risk associated with earnings and dividend announcements increase the price of the call options sold. This increases option premium income for the seller.
Long term covered call sellers often get to capture the dividend paid by the underlying stock since these stocks are held for longer time frames.
Read my related post In the Money Covered Call Strategy.
Disadvantages of Long Term Covered Calls
Higher Bid Ask Spreads
As written above, long term options often have lower volume than short term options making the bid ask spread higher.
Fewer Income Opportunities
A short term covered call writer may receive premium income ten to forty eight times a year. A long term call writer, on the other hand, may receive premium income four to eight times a year, depending on the time frame chosen.
Many long term covered call writers sell options three months out. Since both earnings and dividends are announced quarterly, or every three months, both of these factors increase the risk associated with owning the underlying security for long term covered call strategies due to the lower stock price predictability.
If a company cuts the common stock dividend, for example, the stock’s price usually tanks. And earnings misses often lead to big drops in stock prices.
Now that you’re seen the advantages and disadvantages of short term and far out covered calls, let’s see what else is important to choose the best time frame for selling covered calls.
Read my post Covered Calls for Income to see a real covered call example where the stock dropped significantly after I bought it! This post has covered call calculations for various covered call outcomes.
Pace of Price Movement
A stock in a strong and fast uptrend is more likely to reach the option strike price in less time than a slow moving stock.
Such a stock is more likely, therefore, to exceed the option strike price weeks or even months before the option expiration date when selling long term covered calls.
When this happens, your capital is tied up until the option expiration date in a stock that has already reached it’s maximum potential, except for possibly dividends.
This means that the further out the covered call is, the less efficient it is from a capital perspective when this happens.
One of the most common complaints about selling covered calls is missing out on the capital gain if the underlying stock rises since option sellers are committed to sell the stock at the option strike price.
This disadvantage is less likely to occur when covered calls are sold close in vs far out in time. It applies to fast, up trending stocks, in particular.
Read my related post Are Dividends or Capital Gains Better?
The Best Time Frame for Covered Calls
As you have seen, there are many advantages and disadvantages to covered calls sold both far out and close in. Only you can decide the best time frame for your own covered call strategy.
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