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A Basic Stock Options Strategy – Selling Covered Calls

by John Schroeder

There are several basic strategies that can be used by traders who are new to stock options that don’t involve a lot of risk. A common concern of many investors is that all option trading strategies are risky and will lose money. While there are plenty of risky option investments, there are also some relatively low risk strategies used to generate considerable profits if implemented properly.

The covered call strategy for example, is considered to be a low risk option trade that can generate a decent amount of cash from existing shares in an investors’ portfolio.

Let’s take a closer look into this option trading strategy.

Selling Call Options

Covered Call Options

Covered call options

For those that are not familiar with stock options, there are two different types. A call option gives the buyer the right to buy an underlying stock at a specified price within a certain period of time. A put option on the other hand gives the buyer the right to sell an underlying stock at a specified price within a certain period of time.

An investor who decides to sell a call option has a different goal in mind compared to the investor who buys options. If the option is exercised, then the seller has an obligation to sell the underlying stock at the strike price. In return for assuming this risk, the seller is paid the premium of the option which they are free to keep no matter the outcome.

What Does Covered Mean?

The term “covered” means that the seller (that’s you) can cover his/her position if the buyer exercises their option. For example, if you decide to sell 5 covered call options, then as the seller you need to own 500 shares of the underlying stock.

Selling a covered call is considered a low risk options strategy as you have the shares to back up your trade if you need them. The opposite of being covered is selling a “naked” option, which is much riskier. Selling naked options means that you don’t own the stock and would be required to buy it at its current price and sell it back to the buyer for the strike price.

Steps to Selling Covered Calls

There are a few important steps that you need to be aware of when selling covered call options. Here is an oversimplified list of steps an investor needs to take in order to successfully implement this basic options strategy.

  1. Buy the Stock – In order to be “covered” on your trade, you first must own the underlying stock. Remember that for every option contract you sell, you must own 100 shares of the stock. Your broker will not allow you to place the trade without these shares in your brokerage account. A broker will also require special approval in order to trade options, so a standard online brokerage account may or may not offer this feature.
  2. Find ‘Out of the Money’ Options – It is helpful to look for call options for your stock that are out of the money. A call that is out of the money will have a strike price that is higher than the current share price of the stock. For example, you may find an option for a stock with a strike price of $55 and the share price is currently at $50. This contract would be out of the money until the share price hits $55.01. Once that threshold is passed, then the option contract is considered in the money.
  3. Look for Soon to Expire Contracts – Another important step that can be used to limit your risk is to look for soon to expire call option contracts. Most investors who sell covered calls don’t actually want to lose the stock and would prefer it to expire without being exercised. Since options are time sensitive, the seller should look to limit the total time the option is open. It is a good rule of thumb to look at call options that expire no more than 2 months out.
  4. Analyze the Potential Trade – Even though you may have found a call option that is out of the money and expires in less than two months, it is important to analyze the trade. For example, if a potential covered call option trade will only net you $20, then it may not be worth risking your shares. Take the time to calculate how much you will profit from the trade and what would happen if your call option is exercised.
  5. Place the Sell Order – Once the analysis has been completed on the call option and the trade seems favorable, it is time to place the order. Work with your online discount broker to place a sell order to open transaction.

Possible Outcomes from Selling Covered Calls

Even though selling covered calls is thought of as a low risk option trading strategy, there are several potential outcomes. Most of the time, the results will depend on overall market conditions as well as the performance of the stock. If the stock does poorly, then there is a good chance the option will expire. However, if a stock performs well, then the seller may be forced to sell their shares.

Here are a few possible outcomes from selling covered calls -

  • Option Expires Without Being Exercised – As the seller, you will profit the premium less any commissions and retain the stock. The buyer of the call will be out the premium paid to you the seller.
  • Option is Exercised on or Before Expiration Date – The seller must sell their shares of the stock to the buyer at the strike price. They will receive the funds from the sale of the stock as well as keep the premium. The buyer purchases the shares and is out the premium paid for the right to purchase.
  • Purchase Back the Call Option – The seller decides to buy back the call options to avoid losing the stock or in some cases to take profits.

Final Thoughts

Selling covered calls provides a tool for investors to generate extra income just from owning a stock. In return for earning this extra income, the investor is potentially risking their stock and may be forced to sell it for less than market value. Learning how to properly trade options takes time and practice. While the covered call strategy may not be as risky as others, it is still important to analyze the risks versus rewards for each possible trade.

If you would like to learn more about options and covered calls, then you can check out the Chicago Board Options Exchange strategies section for more details.

Photo credit: Perpetualtourist2000


Published or updated March 15, 2013.
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{ 8 comments… read them below or add one }

1 JoeTaxpayer

This can be a great tool to use in a flat to slightly up market.
I don’t trade covered calls as frequently as I should, but I just placed a new one in June, I’ll share the details.
MU (Micron technology) – trading at $8.72 – looked properly valued, expected no huge upside. Sold the Jan ’12 $7.50 call for $3.00 even. So – I own the stock for $5.72 out of pocket, but am obligated to sell it at $7.50, this is a 31% return over 19 months (the expiration id 3rd fri in Jan, I’ll count that as a month) or a near 20%/yr return.
At present, the stock is down to $7.29, 17%, but my position will still be +27% if it’s this price in Jan ’12.
Consider, I would have a zero return (but not negative) if the stock were down 35% from my purchase price come next January. If I were able to create a diversified portfolio reflect these numbers every year or so, a 10 year flat market would have been a spectacular one for me.
(You just inspired me to write a full article of my own, don’t know why I’ve never discussed this topic on my blog)

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2 Dividend Monk

Selling covered calls can certainly be a good investment, and so can selling puts.

Options seem to have a bad reputation among many reasonable investors, but when fully understood, option strategies can be used to increase income or decrease risk, or provide reasonable returns in a sideways or decreasing market.

I view them as great supplements to a dividend-based portfolio.

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3 John

Glad I could give you some inspiration. I really like the thought of selling covered calls, but I have been burnt by them in the past. My one concern with your scenario is the time that you have to wait (19 months) till expiration.

Is this a stock that you are long on? Or is it one that you don’t mind losing in the end?

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4 JoeTaxpayer

I did this trade (both the stock buy and selling the call) at once. I did it with the expectation the stock had some upside potential, but I’d be ok if it got called away. The call pricing reflected high volatility. I like this particular trade for its risk/reward profile, and the time is on my side as I expect some recovery to Micron’s end market (i.e. users of electronic components)

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5 John

@Joe – Sounds like you really did your homework on this one by taking advantage of the volatility!

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6 Evan

Covered Calls are a great way for some income in a flat market. I was doing it with lost cost stocks like SIRI and ETFC (before the reverse split brought me from 500 shares to 50 lol)

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7 Reece Mak

I want to know if I sell a call contract(covered call). Do I just simply sell a call contract and leave the shares in my account wait til the expiration date? or do I have to do anything to tie the contract with the shares?

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8 John

@Reece – Are you approved to trade options through your brokerage account? That is the first step. If you are, then you need to make sure you first own 100 shares of the stock for every 1 options contract you plan to sell. Then you need to place a ‘sell to open’ trade for the options contract you are looking to sell.

The answer to your question is – Yes. Once you sell the contract, you need to leave the shares in your account until one of the following – the option gets called meaning you have to sell your shares, the expiration date expires, or you decide to buy the option back by placing a ‘buy to close’ trade.

Hope this helps – good luck!

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