Investors looking for ways to increase portfolio income other than selling stock may want to consider implementing a covered call strategy. Let’s review the basics of a covered call and look at the ins and outs of how to sell them to generate covered call income. We’ll look at choosing the right stock, selecting the right option, and managing the trade.
The intent of a covered call strategy is to generate income on an owned stock that you do not expect to increase much in price during the term of the options contract.
A call option is a contract that gives the holder (buyer) the right, but not the obligation, to buy a security at a specified price for a certain period of time before the expiration date. The seller receives an option premium up front. In most cases, the buyer of one call stock option has the right to buy 100 shares of the underlying stock.
The main benefit of covered calls is they allow investors that sell covered call option to generate income from their portfolio without an outright sale of the underlying stock. The buyer pays a premium upfront.
The seller keeps the premium regardless of the outcome of the option at expiration. If the buyer doesn’t exercise the option before it expires, the owner of the stock makes additional income on that asset without having to sell the underlying asset.
Covered calls are called “covered” because the seller owns the underlying stock. If they didn’t, and the buyer exercised their option, the seller would have to purchase the stock at market rate and sell it to the option holder for the agreed-upon strike price. Writing an option on a stock you don’t own is called a “naked call” and it is much riskier than covered calls.
Covered calls may be part of a broader strategy to generate cash from an investment portfolio. You can even use covered calls to increase your IRA income.
The Snider Investment Method from Snider Advisors is a strategy that uses a combination of stock, options, and cash, along with specific techniques applied in a specific sequence, to maximize a portfolio’s income potential.
The basics of selling covered calls involves choosing the stock, selecting the right covered call option, and monitoring the trade. As you will see, there are many moving parts to setting up your strategy for selling covered calls.
Investors today can take advantage of helpful tech tools that were not available in years past. Call screeners like optionDash are a great example. A covered call screener is a dashboard that allows you to set filters for selecting stock, strike prices, and expirations for your ideal covered call. This helps you quickly compare many different stocks in a way that would be extremely time consuming to keep up with in a spreadsheet.The basics of selling covered calls involves choosing the stock, selecting the right covered call option, and monitoring the trade. Click To Tweet
Investors can write covered calls against any position where they own at least 100 shares. While the goal is to keep the premium and the stock, there is a risk you will have to sell the stock to the option holder if the buyer exercises the option.
Therefore, it may seem obvious but you may want to avoid writing options for stocks you want to keep, or if you are not ready for capital gains tax implications if the price ends above the call’s strike price.
Similarly, if you are selecting stocks to buy to write covered calls, consider choosing stocks that you don’t mind having a long position with in case the value decreases. It’s also a good idea to consider the timing of events that might impact the price such as an upcoming dividend payment or earnings announcement.
There are many metrics to consider when selecting stocks for covered calls. Mastering selecting stocks for covered calls requires some patience and a lot of practice.
As we mentioned above, covered call screener are the easiest way to compare stocks. optionDash is a comprehensive screener that enables sorting by downside protection, if-called return, or annualized return. We also provide proprietary Quality, Value, and Trend scores to quickly evaluate the underlying stock.
Every option has a strike price and expiration date. Investors manipulate those variables to reflect lower and higher levels of risk and income.
Long-term investors may choose to minimize the risk of losing the stock and often prefer out-of-the-money options. Investors looking to maximize income and downside protection may prefer in-the-money or at-the-money covered calls.
Similar to picking stocks, choosing the covered call variables involves some complexity. Screeners like optionDash not only help you choose stocks for covered calls, but also helps you select the best strike prices and expiration dates. You can compare metrics to determine the right risk/reward combination for your situation.
Long-term investing requires a buy-and-hold mentality. For those new to covered calls, implementing a successful strategy may require some adjustment for investors not used to frequently checking in with their portfolio.
In general, you will see most of the activity on covered calls in the final week leading up to expiration. However, anytime stock prices change unexpectedly investors need to be aware so they can consider taking action.
If a stock increases suddenly, you may need to buy back the option to avoid having to sell it and triggering a capital gains tax event. If the stock falls, you need to decide if they are going to sell it or hold onto it. When the stock prices move in unexpected ways, investors may look at options for “rolling” the covered call.
Much like it sounds, when you roll a call, you close out the initial call with a buy-to-close order and sell another one to replace it at the same time. Conceptually, this is like rolling the first covered call into a new one. Different types of rolling depend on changes to strike price, and expiration date.
The Bottom Line
Learning how to choose stocks, write covered calls, and manage your trades takes time and learning. Learning the fundamentals is key.
For more in-depth strategies, you can check out resources like The Snider Investment Method from Snider Advisors to create a comprehensive strategy that covers all the bases. Tools like our optionDash screener and Lattco help you compare stocks and make the best investment choices.
If you are interested in a covered call strategy for earning income from your portfolio but you don’t have time to manage the process, Snider Advisors also provides a done-for-you solution via their asset management services. Contact them for a free consultation to learn more.Posted in Covered Calls |