Start Your Own Covered Call Strategy

Jesse Anderson

With the current market conditions, investors are looking for ways to mitigate the negative effects of volatility and inflation. For the right investor, a low-risk covered call strategy can be a good inflation hedge.

For the right investor, a low-risk covered call strategy can be a good inflation hedge. Click To Tweet

Most investors that sell covered call options do so to generate extra income from the stocks they own or are interested in purchasing. Because a covered call is less risky than some other ways of trading options, many brokerages allow individual investors to “write” and sell covered calls to boost portfolio income.

If you haven’t created a strategy to generate income from covered calls, here are some considerations when setting up your covered call strategy.

What Is a Covered Call?

If you own a stock, you have the right – or option – to sell it at any time for the market price. If you decide to sell this option, you can create an agreement that sets a predetermined stock price (strike price) and an expiration date. In return, the buyer pays you a premium.

A covered call option is a contract that gives the buyer of the call option the right, but not the obligation, to buy a security at an agreed-upon strike price before the expiration date.

The main attraction of selling call options is that the buyer pays a premium upfront. As the seller, you keep the premium regardless of the outcome of the option at expiration. If the buyer doesn’t exercise the option before it expires, you have made additional income on that asset without having to sell the underlying shares.

Every covered call option includes these components:

  1. The underlying asset.
  2. A strike price – an agreed-upon share price for the period of the option.
  3. A premium
  4. An expiration date.

As we covered, if you write an option call and sell it to a buyer, you are obligated to sell the stock to them at the strike price, should they exercise that option.

That means if you don’t already own the stock before they exercise their option, you must purchase it at the market rate and sell it to the option holder for the agreed-upon strike price.

Call options where you don’t own the stock before you sell the option are called “naked calls”, and they are much riskier than covered calls.

In most cases, the buyer of one call stock option has the right to buy 100 shares of stock. So, to create a covered call, you’ll need to own at least 100 shares of stock.  You do not need to sell a covered call for all the shares you own, but each option contract will cover 100 shares.  If you don’t own the underlying shares and sell a naked call, it creates a risk of unlimited losses.  This is why it is a very risky strategy and not recommended for most investors. 

How profitable are covered calls? That depends largely upon these factors:

  • Strike Price – Call options with a strike price less than or close to the current price typically have higher premiums since there’s a good chance that the buyer could exercise the option.
  • Implied Volatility – Volatile stocks typically have call options with higher premiums since there’s a higher likelihood that the stock moves enough to reach the strike price.
  • Time Until Expiration – Call options with a long time until expiration trade at higher premiums since there’s more time for the underlying stock to move and reach the strike price.

What to Consider When Setting up Your Covered Call Strategy

In context with long-term strategies like the Snider Investment Method, covered calls are part of a strategy that uses a combination of stock, options, and cash, along with specific techniques applied in a specific sequence, to maximize your portfolio’s income potential.

One reason covered calls are popular is that they can be a profitable way to generate income from a portfolio without an outright stock sale. Success depends on a range of factors. Here are some things to consider:

  1. Possibility of earning repeat premiums: If the option expires and the buyer has not exercised it, you can write additional covered calls for that stock and receive additional premium payments.
  2. Risk of losing underlying stock: It seems obvious but in a drive to maximize premiums investors may lose sight of the bigger picture. If you own stock that you don’t really want to sell, you probably should avoid writing calls on it.
  3. Limits on the upside: with a covered call strategy, you limit the downside risk by the premium received from the option sale. The flip side is that there is also a limit on how much you can earn from an increase in the stock’s price. Your upside is capped at the option’s strike price. 
  4. Constraints on the right to sell the stock: For a covered call, you must hold the stock for the duration of the option term. You cannot sell the stock before the option expires.
  5. Tax implications for covered calls:  Tax implications and reporting for covered calls are complex. Tax planning may make a covered call strategy less appealing depending upon your situation. Net gains and losses on covered calls are treated as short-term capital gains and losses. Gains are taxed like ordinary income. You could end up paying more in taxes than you would with long-term capital gains.
    a. Be sure to consult with your accountant and set up your recordkeeping workflow and strategy before you ramp up your activity with covered calls.

How to Start Covered Calls

While there will always be market forces outside of your control, your success largely rests upon how well-informed you are. As an individual investor, you are responsible for the performance of your covered call strategy. But that doesn’t mean you need to go through this process alone.

Step One for a Covered Call Strategy Is Education

Since 2002, our parent company Snider Advisors has been teaching investors how to manage a portfolio of covered calls. Financial education and do-it-yourself investments are two pillars of our companies’ investment philosophies. Snider Advisors has extensive, high-quality videos and other resources you can access to learn about covered calls and other investment topics, from the basics to more advanced concepts and specifics of how to write covered calls.

Set Your Goals for Your Covered Call Strategy

Every investor is unique. Your covered call strategy should reflect your specific situation, personality, and time available to execute and monitor your strategy.

Covered Call Recordkeeping for Taxes

As mentioned above, recordkeeping for covered calls and tax time can be complex, so be sure to have a system set up to capture the data you will need for tax time before you generate a lot of covered call activity. These days most brokers make tax time easy with all the necessary documentation to report your gains and losses.  Finally, you can trade covered calls in retirement accounts that have very few tax reporting requirements.

Research Tools and Screeners for Covered Calls

Writing covered call options requires extensive research. Fortunately, there are tools to help you with that. Choosing the right tool is essential. OptionDash’s screener provides unlimited searches and real intraday data without ads. You can get started for free, too.

The Bottom Line

Are you a patient investor with an existing stock portfolio?  Do you want to boost the income from your portfolio and reduce the risk?  With a little time and research, you can learn the skills necessary to implement a successful covered call strategy. Selling covered calls may be a great “option” for you! Check out Snider’s free e-course today and sign up for optionDash’s free covered call screener to get started.

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