When investors think about generating income from stock holdings, they typically only think about dividends. There is another way to generate income, though. When you sell a call option which is backed by stock shared you own you receive a “premium” which is immediately credited to your account balance. This type of short call option is known as a covered call, and since the buyer demands the shares he has paid for the right to buy at a given price, then the option is covered by the fact that the buyer has shares to tender. If the buyer did not own the underlying shares, but sold a call option anyway, that is known as a “naked” call option. The term “buy-write” is used to describe the same strategy, but when you simultaneously purchase the stock shares and sell the covered call option.
Options contracts are lots of 100 shares of an underlying stock. You can only trade options in full contract increments, so you will need at least 100 shares of a stock if you want to sell a covered call. What you are really selling is the right to purchase your shares at a set price on or before a set date. If the price of the underlying stock is even slightly higher than the set price you settled on at expiration, your shares will be sold on assignment at the strike price. You will be paid the strike price for each of your shares minus any commissions. Options can be executed earlier than the expiration date at the call buyers discretion. The call buyer may want to execute early to qualify for an ex-dividend date or some other event.
If added income is your goal, you would typically sell an option with a strike price higher than the current price of the stock. This would ensure you get the income (premium), but not sell the underlying shares unless the stock price increased beyond the strike price. The more “out of the money” the strike price is, the lower the premium you will get. The shorter the time to expiration, the lower the premium you get. You will have to balance these factors to decide which strike prices and expiration dates if any you are interested in.
If you are new to covered calls, you might mistakenly start to think there is no way you can lose. Get that thought out of your head before you sell your first covered call. If the price of the underlying stock drops, you still have that paper loss in your portfolio. If you would have held the stock through the drop anyway, the worthless covered call will cushion your loss slightly, but only slightly. The real risk to a covered call strategy is that you are limiting your upside potential during the lifetime of the option. If the price of the underlying stock increases greatly, you may only capture a small percentage of the gain plus the option premium.
Some stocks are better choices than others if you are looking to boost your income by selling covered calls. Stable stocks like Coca-Cola (KO) do not command much of a premium on the options. If you want to sell a covered call with a strike price of about 10 percent higher than the current price, the premium may only give you about a 1 percent return for a expiration date nine months out. If you only have 100 shares (one contract), the commissions will eat up a significant portion of the premium. More volatile stocks command much higher premiums. In the same nine month time-frame, you could easily get a 10 percent premium on a strike price 15 percent higher than the current price for a volatile stock.
There have been many studies showing that the majority of options expire worthless. This bias against the purchaser conversely indicates an advantage for the seller. Option buyers are usually speculating or hedging. While these can be solid strategies, they are not strategies that often pay out. Figures often mentioned indicate that 75 – 85 percent of options expire worthless. This figure often includes futures options and commodity options. For stock call options, the number is probably in the 60 – 70 percent range. Of course you cannot assume these figures will guarantee you will get a better return than if you did not sell covered calls. Make sure your trades make sense for what you are trying to accomplish in your portfolio.
In this climate of low interest rates, it makes sense to look into other sources of income. Adding covered calls to your investment toolkit is a great way to do just that. Don’t let the tail wag the dog, though. Do your due diligence to pick appropriate stock holdings for you investment portfolios. Review each holding to see if rewards of selling a covered call outweigh the risks of limiting potential upside. If so, by all means consider selling a covered call option to add some extra income.