The Beginner’s Guide to Making Your First Covered Call Trade
Jesse Anderson
Covered calls are one of the most popular options strategies for investors seeking to boost income – especially during retirement. And it’s one of the few strategies you can use in an IRA! But before you dive in and start selling call options, you should take the time to understand how the strategy works and be comfortable with its risks.
In this guide, we’ll dive into how covered calls work and give you a solid foundation, from options terminology to the mechanics of your first trade.
Understanding the Basics
A covered call is when you sell someone else the right to buy a stock you own at a specific price, within a specific time frame. This “specific price” is known as the “strike price,” and the “specific timeframe” is what we call the “expiration date.” In exchange for selling this right, you’re paid a fee, or “premium.” In essence, you’re renting out your stock’s upside!
As you might notice, options have their lingo. Understanding these terms and what they mean is like learning to read music before you play an instrument. It’s less about memorization and more about getting comfortable with the concepts so they become second nature.
The key terms to know include:
- Strike Price: The agreed-upon price for the stock in the option contract.
- Expiration Date: The deadline for exercising the option.
- Premium: The fee received by you for selling the option.
- Exercising the Option: When the buyer takes your shares.
- At-the-Money: When the stock price is equal to the strike price (for a call option).
- In-the-Money: When the stock price is above the strike price.
- Out-of-the-Money: When the stock price is below the strike price.
In addition to these terms, option diagrams (like the one below) can provide a roadmap to understanding potential outcomes. On the horizontal axis (the X-axis), you have the stock price at expiration. And on the vertical axis (the Y-axis), your profit or loss.
The line’s curve shows your possible outcomes. The flattening of the line on the right represents your maximum upside since you’re obligated to sell at that strike price. Your breakeven point is where the line crosses the horizontal X-axis. As it moves below the axis, the losses from the decline in the stock price offset your income from the option premium.
Getting Started
Options aren’t your standard stock trade. You need an options trading account. Different brokers have different rules and hoops to jump through to set up an account. But generally, you’ll need to sign an options agreement covering your investment objectives, trading experience, personal financial information, and an indication of what options you want to trade.
After setting up an account, you’ll need to purchase stock. And not just a share or two, you’ll need at least 100 shares of stock to sell one covered call. That’s because each option contract represents 100 shares. Owning the stock means your call is “covered” – you’re not making an empty promise, you’ve got the shares to back up your promise to sell!
Choosing the Right Stock & Option
Covered calls involve selecting both an underlying stock and an option contract for the stock, making it a little more difficult than a stock-only investment decision. You need to make sure you pick a stock that you’re comfortable owning long-term while simultaneously ensuring that it’s profitable and suitable for a covered call position.
If you’re a long-term investor, start by choosing a stock that you’re comfortably holding onto long-term. Without naming names (because this isn’t financial advice), think big, established companies with a track record of steady performance. Typically, you also want to avoid dramatic earnings surprises or wild market swings.
Fortunately, many tools can help you assess a stock’s suitability for covered calls. For instance, optionDash (seen below) is an option screener that offers a Research section where you can see the quality, value, and trend scores for a company. And even better, you can see when the next earnings date is to avoid any volatile surprises!
On the other hand, if you’re looking to maximize income, you may prefer to start with the option contract and work backward to the stock. For example, you can use optionDash to sort covered call opportunities by the potential premium income (if-called return). Then, you can determine if the underlying stocks are too risky or not for your portfolio.
When looking at options, you have two crucial decisions: Picking the strike price and the expiration date.
The strike price is the price at which your stock can be bought if the option is exercised. Here’s the balancing act: Set it too high, and you might miss out on extra premium income. Set it too low, and you risk missing out on potential upside.
The expiration date is when the option expires. Short-term options provide more flexibility, but they’re more work to establish new positions. Meanwhile, longer-term options give you a higher premium upfront, but they also mean a longer commitment. So, there’s a trade-off. In general, it is best to stick with shorter term options when selling covered calls. The time premium decays more rapidly as expiration approaches. Sticking with options that expire in less than 3 months makes the most sense.
There’s no one-size-fits-all approach to choosing the right strike price and expiration date. If you’re a long-term investor, you might set the strike price further out-of-the-money to ensure you don’t have to sell and write them occasionally. But if you’re maximizing income, you might choose at-the-money options offering the highest premium and write them more frequently.
Executing & Managing the Trade
You’ve done the prep work. Now it’s game time – executing your covered call and managing the trade depending on how the stock reacts over time.
The good news is that executing covered call trades is pretty straightforward. If you already own the stock, you can simply execute a trade selling a call option at the strike price and expiration date of your choosing (remember you must own 100 shares per option you sell!). And if you don’t own the stock you can purchase a long stock and then execute the option trade.
But, once your trade is live, it’s not time to kick back and relax.
You’ll need to be ready for a few scenarios:
- Rolling Out: If your option is nearing expiration and is near-the-money or in-the-money, consider “rolling out.” This means you’re buying back your original call and selling a new covered call with a later expiration date to give yourself more time and avoid assignments.
- Rolling Up: If the stock’s price is soaring above your strike price, “rolling up” might be your move. This involves buying back the original option and selling another with a higher strike price to avoid assignment.
Why would you want to avoid assignment? Taxes. You owe capital gains tax on any long stock positions you sell. And if you held that stock for less than one year, you typically pay a much higher tax than if you held the position for over one year. Therefore, if you can, you’re better off holding stock for one year before selling, and that means avoiding assignment.
So, rolling options shouldn’t be taken lightly. Before you roll, consider transaction costs and tax implications. And remember, each roll is a new decision, with its risks and rewards.
The Bottom Line
And there you have it – a journey through the world of covered calls. While we’ve covered everything from option basics to executing and managing your trades, remember this is just the beginning. The real learning comes from getting your hands dirty and navigating the market’s ups and downs, as well as digging deeper into these topics.
If you’re looking for a more in-depth introduction to covered calls, Snider Advisors also offers a free e-course that teaches the basics and the proprietary Snider Investment Method. Sign up today for free!
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