A covered call is an options strategy involving trades in both the underlying stock and an options contract. The trader buys or owns the underlying stock or asset. Selling covered call options against the stocks is a consistent way to earn recurring income and is mainly used in The Wheel Strategy. After all, having an asset and not collecting rent on it is opportunity lost. Owning stocks and not selling options against them is like owning an apartment building and not renting out the units.
Over 75% of all options held until expiration expire worthless. That’s why you should do what the pros do and sell options to other people. After all, if most of them will expire worthless, why not collect some money for them today while they still have value? It’s what you were born to do!
Investing in covered calls is not a get-rich-quick strategy. It’s an income-oriented approach that anyone can do (and if you like receiving dividends, you’ll love receiving call premium each month).
Exercising the Option Contract
If the option contract is exercised (at any time for US options, and at expiration for European options) the trader will sell the stock at the strike price, and if the option contract is not exercised the trader will keep the stock. For a covered call, the call that is sold is typically out of the money (OTM), when an option’s strike price is higher than the market price of the underlying asset. This allows for profit to be made on both the option contract sale and the stock if the stock price stays below the strike price of the option.
If you believe the stock price is going to drop, but you still want to maintain your stock position, you can sell an in the money (ITM) call option, where the strike price of the underlying asset is lower than the market value. When selling an ITM call option, you will receive a higher premium from the buyer of your call option, but the stock must fall below the ITM option strike price—otherwise, the buyer of your option will be entitled to receive your shares if the share price is above the option’s strike price at expiration (you then lose your share position). Covered call writing is typically used by investors and longer-term traders, and is used generate a monthly income.
How to Create a Covered Call Trade
1. Purchase a stock, buying it only in lots of 100 shares or use the 100 stocks you already own.
2. Sell a call contract for every 100 shares of stock you own. One call contract represents 100 shares of stock. If you own 500 shares of stock, you can sell up to 5 call contracts against that position. You can also sell less than 5 contracts, which means if the call options are exercised you won’t have to relinquish all of your stock position. In this example, if you sell 3 contracts, and the price is above the strike price at expiration (ITM), 300 of your shares will be called away (delivered if the buyer exercises the option), but you will still have 200 shares remaining.
3. Wait for the call to be exercised or to expire. You are making money off the premium the buyer of the call option pays to you. If the premium is $0.10 per share, you make that full premium if the buyer holds the option until expiration and it is not exercised. You can buy back the option before expiration, but there is little reason to do so, and this isn’t usually part of the strategy..
Continue ready on the next page for an example and to discover the risks and rewards of the covered call options strategy.