Covered Calls Explained: A Beginner’s Guide to Options Trading
If you’re new to options trading and want to learn how to generate consistent income from your stock investments, covered calls might just be the strategy you need. This comprehensive guide breaks down covered calls in a simple, approachable way — using real stock examples and clear math to help you understand the opportunities and risks involved. By the end, you’ll see why many investors love covered calls and how you can start using them to enhance your portfolio.
What Are Covered Calls?
Primary Concept
A covered call is an options strategy where you own shares of a stock and sell call options against those shares. This means you give someone else the right, but not the obligation, to buy your stock at a predetermined price (strike price) within a specific time frame (expiration date).
Why Investors Use Covered Calls
- Generate steady income: Selling call options generates immediate cash, known as the premium.
- Downside protection: The premium collected cushions potential losses if the stock price drops.
- Simple to execute: Easier than many other options strategies, making it great for beginners.
How Covered Calls Work: A Real-Life Intel Example
To make this concrete, let’s walk through a real-life example using Intel (Ticker: INTC) stock.
Setup
- Stock price: $32 per share
- Call option strike price: $34
- Option premium: $1.50 per share
- Contract size: 100 shares per option contract
- Expiration: Approximately two months from now
What Happens When You Write a Covered Call?
You buy 100 shares of Intel at $32 each. Then, you sell one call option contract with a $34 strike price, expiring in two months, and collect $1.50 per share (total $150).
Four Possible Scenarios After Writing a Covered Call
Scenario 1: Stock Price Falls
Intel drops from $32 to $30.
- You lose $2 per share on the stock ($32 – $30).
- But you keep the $1.50 premium from selling the call option.
- Net loss: $0.50 per share instead of $2, thanks to the premium.
Scenario 2: Stock Price Stays Flat
Intel remains at $32.
- You neither gain nor lose on the stock.
- The call option expires worthless because the buyer won’t pay $34 when the stock is $32.
- You keep the $1.50 premium as pure profit.
- Return: $1.50/$32 = 4.6% gain in two months, annualized to about 28%.
Scenario 3: Stock Rises Slightly
Intel rises from $32 to $33.
- You gain $1 per share on the stock.
- The call option still expires worthless (stock price < $34).
- You keep the $1.50 premium.
- Total profit: $2.50 per share, a 7.8% gain in two months, annualized to 46.8%.
Scenario 4: Stock Price Surges
Intel jumps from $32 to $40.
- The call buyer exercises the option and buys your stock at $34.
- You make $2 per share on the stock ($34 – $32).
- Plus, you keep the $1.50 premium.
- Total profit: $3.50 per share, an 11% gain in two months, annualized to 66%.
- Trade-off: You miss out on the extra $6 per share above $34.
The Key Trade-Off: Income vs. Upside Potential
Covered calls offer guaranteed income upfront but limit your stock’s upside potential. If the stock soars well beyond the strike price, you’re obligated to sell at the strike price, missing out on additional gains.
Would You Be Upset?
It depends on your investment goals and market expectations. Many investors accept this trade-off for consistent income and risk reduction.
Important Variables in Covered Calls
1. Strike Price
- The closer the strike price to the current stock price, the higher the premium you receive.
- Higher strike prices give more upside potential but lower premiums.
2. Duration (Expiration Date)
- Longer expiration dates mean higher premiums because of increased uncertainty.
- Shorter durations allow you to sell multiple calls over time but carry the risk of fluctuating option prices.
Comparing Short-Term vs. Long-Term Covered Calls
Using Intel as an example:
- Two-month $34 call option premium: $1.50
- Six-month $34 call option premium: $2.61
Which Is Better?
- Selling multiple two-month calls over six months could theoretically earn more ($1.50 × 3 = $4.50) than one six-month call ($2.61).
- However, stock price and option premiums fluctuate, so you might not always sell the shorter-term options for $1.50.
- Longer-term options lock in premium upfront, offering predictability but less flexibility.
How to Write a Covered Call: Step-by-Step
Step 1: Own the Stock
Buy 100 shares (or multiples of 100) of a stock you believe will perform well.
Step 2: Sell the Call Option
- Choose the strike price and expiration date.
- Sell (“write”) the call option contract(s).
- Collect the premium immediately.
Step 3: Monitor Your Position
- If the stock price rises above the strike price by expiration, you may have to sell your shares at the strike price.
- If the stock price stays below the strike price, the option expires worthless, and you keep your shares and premium.
Practical Tips for Writing Covered Calls
Choose Quality Stocks
Don’t pick stocks just for high premiums. Ensure the stock’s fundamentals support your investment goals. Avoid “picking up pennies and dropping quarters” by losing money on poor-quality stocks.
Use 100-Share Increments
Options contracts represent 100 shares. Own multiples of 100 shares to match the number of contracts you want to sell.
Partial Coverage Is an Option
You don’t need to write calls on all your shares. For example, if you own 500 shares, you can sell 1 to 5 call contracts depending on your strategy.
Understanding Option Premiums
The premium is the price buyers pay for the option contract. Factors influencing premium size include:
- Time until expiration: More time equals higher premium.
- Strike price proximity: Closer strike prices to current stock price yield higher premiums.
- Stock volatility: More volatile stocks command higher premiums as their prices fluctuate more wildly.
Risks to Consider
- Limited upside: Your stock gains are capped at the strike price plus premium received.
- Stock declines: While premiums reduce losses, they don’t eliminate downside risk on the stock.
- Opportunity cost: If stock price jumps significantly, you might regret having capped your profit.
Managing Risk and Rewards
Covered calls aren’t a “set and forget” tool. Regularly assess if the trade-off aligns with your financial goals. If the premium doesn’t sufficiently compensate for the limited upside, reconsider the trade.
Final Thoughts: Is Writing Covered Calls Right for You?
Covered calls are an excellent strategy for investors seeking additional income with manageable risk. They work best on stocks you’re comfortable holding long-term and that have stable or moderately rising prices.
Remember to shop around for good deals on options premiums and strike prices. Sometimes the market offers great opportunities; other times, it’s better to wait.
Where to Learn More and Stay Updated
For ongoing tips, real-time option ideas, and community discussions, check out specialized websites and forums dedicated to options investing. Many investors share their favorite covered call opportunities, helping you learn and grow your income strategy.
Frequently Asked Questions (FAQ)
Do I need 100 shares to write a covered call?
Yes. Each options contract covers 100 shares, so you must own 100 shares per contract you want to write.
Can I lose money selling covered calls?
You can lose money if the stock price falls significantly, but the premium collected helps offset losses.
What happens if the stock price goes above the strike price?
You may have your shares called away (sold) at the strike price, limiting your gains to that price plus premium.
How often can I write covered calls?
You can write calls as often as contracts expire, but consider transaction costs and market conditions.
Covered calls are a powerful tool in the options trader’s toolkit, balancing income generation with risk management. By understanding the mechanics, scenarios, and variables involved, you can confidently add this strategy to your investing arsenal. Happy investing!
