The Basics Of Covered Calls: Generating Income From Your Portfolio

When it comes to investing, one of the most attractive aspects for many is the ability to generate passive income. One of the strategies that allow investors to do this is through selling covered calls. It’s a relatively simple options strategy that can be used to generate extra income from stocks you already own in your portfolio.

In this post, we’ll cover the basics of covered calls, how they work, and how you can use them to boost your portfolio’s returns.

What is a Covered Call?

Let’s start with the basics. A covered call is an options strategy that involves selling a call option on a stock that you already own. In exchange for selling this call option, you receive a premium, which is essentially the payment from the buyer of the option.

If the buyer chooses to exercise the option, you may have to sell your shares at the strike price. If not, you simply keep the premium. The term “covered” refers to the fact that you already own the shares you’re selling the call on, which makes this a less risky options strategy compared to selling “naked” calls.

How Covered Calls Work

Imagine you own 100 shares of a stock currently trading at $50 per share, and you sell a covered call with a strike price of $55 for $2 per share in premium. Here’s how the scenario could play out:

1. If the stock price stays below $55: The option will expire worthless, and you get to keep both your 100 shares and the $200 premium (since you sold the call for $2 per share on 100 shares).
2. If the stock price rises above $55: The buyer of the call option may choose to exercise their right to buy your shares at $55. You would have to sell your 100 shares at $55, but you still keep the $200 premium from selling the option. Even though you might miss out on the extra gains above $55, you’ve still locked in a profit.

The Appeal of Covered Calls for Income Generation

One of the main reasons investors use covered calls is to generate additional income. Since you collect a premium every time you sell a call option, this can provide a consistent cash flow if you’re using the strategy regularly.

For example, let’s say you use the covered call strategy every month. You could potentially collect a premium 12 times a year, adding a significant boost to your returns, especially if the stock price doesn’t rise too much. This can be a powerful strategy if you’re investing for passive income, such as during retirement.

The Trade-Off: Potential Gains vs. Premiums

It’s important to recognize that covered calls come with trade-offs. The key downside is that you’re capping your potential upside. If the stock price shoots up well beyond your strike price, you’re obligated to sell your shares at the agreed-upon price, potentially leaving money on the table.

For example, if your stock jumps to $60 per share and you sold a covered call with a $55 strike price, you’d miss out on that extra $5 per share gain because you’d have to sell your stock at $55. In this case, you might feel like the premium you received for selling the call wasn’t worth the lost opportunity.

Therefore, it’s important to sell calls at strike prices where you’re comfortable letting go of the stock if necessary. Many investors choose a strike price that is slightly higher than the current stock price but still within reach based on their market outlook.

When to Use Covered Calls

Covered calls can be especially effective in a few different scenarios:

1. In a sideways or slightly bullish market: If you believe a stock is going to stay relatively flat or rise only slightly, selling a covered call can help you earn extra income without worrying too much about losing out on big gains.
2. To lower portfolio volatility: Covered calls can also act as a way to smooth out volatility. The premium you collect from selling calls can provide some downside protection because it adds to your total return, even if the stock’s price remains flat or declines slightly.
3. If you’re willing to sell the stock: If you’re planning on selling a stock in the near future anyway, covered calls can be a good way to squeeze out a bit more income before letting go of the shares. This is particularly true if the stock has appreciated significantly and you’re looking to lock in gains.

Risks of Covered Calls

While covered calls are generally considered a low-risk options strategy, there are still some risks to be aware of:

1. Limiting upside potential: As mentioned earlier, the biggest risk is that you cap your upside. If a stock in your portfolio has a huge rally, you won’t be able to participate in the full extent of those gains.
2. Early assignment: In some cases, the buyer of the option may exercise their right to buy the stock before the expiration date, which could force you to sell your shares sooner than expected. This usually happens when the stock price rises rapidly, and the buyer wants to lock in the stock at the lower strike price.
3. Market declines: Covered calls won’t protect you from losses if the stock price drops significantly. While the premium can offset some of the losses, if the stock price falls sharply, the overall value of your portfolio will still decrease.

How to Implement Covered Calls

If you’re interested in using covered calls, the process is relatively straightforward:

1. Choose a stock you already own: You must have at least 100 shares of the stock for every call option you plan to sell.
2. Pick a strike price: The strike price is the price at which you’re willing to sell your shares. Ideally, this should be a price you’re comfortable with, based on your market outlook.
3. Select an expiration date: Options expire on a specific date, usually one week, one month, or several months from the sale date. The farther out the expiration, the more premium you can collect, but the longer your obligation to potentially sell the stock.
4. Monitor your trade: Once you’ve sold the covered call, you’ll want to keep an eye on the stock’s price movement. If the stock gets close to the strike price, you may need to decide whether to let the option be exercised or buy it back before expiration.

Final Thoughts on Covered Calls

Covered calls can be a great way to generate additional income from your portfolio, particularly in a market where stocks are not expected to rise sharply. However, as with any strategy, it’s important to weigh the pros and cons, particularly the risk of capping your potential gains.

This strategy works best for investors who want to enhance their returns with relatively low risk while holding onto their stocks. If you’re looking to add an income-generating element to your portfolio, covered calls might be worth considering.

As always, make sure to do your own research or consult with a financial advisor to see if this strategy fits your overall financial goals.

About The Author

The Options Geek

Jonathan is the founder of The Options Geek and Freedom Income Strategies. With over 15 years in options and stock trading, he’s dedicated to helping others build resilient passive income streams. His mission is to make financial freedom accessible, empowering individuals to live life on their own terms.

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