Covered calls are one of the main strategies I use to generate monthly passive income. While covered calls are more common in the US than the UK, my aim is to educate readers on the benefits of covered calls and how they can be used to generate consistent cash flow into your account, every single month.
In this article I will also show you a couple of real life examples from my options trading account in ticker symbols TROW and SWK.
Table of Contents
What are covered calls?
Covered calls are an options trading strategy used by investors to generate additional income from their shareholdings. This technique involves selling or writing call options on stocks that an investor already owns, offering someone else the right to buy their shares at a specified price (known as the strike price) before a certain date (the expiry date). As the seller of the call option, the investor receives a premium or payment in return, which can act as an additional source of income.
To initiate a covered call, the investor must own at least 100 shares of the underlying stock in the US, and 1,000 shares of the underlying stock in the UK.
It is essential to understand the associated risks and benefits before implementing this strategy in one’s portfolio. While covered calls can provide investors with income through the premiums received, they also limit potential gains, as the strategy caps the profit received on the shares if the stock price rises significantly above the strike price.
The essential components of a covered call strategy include the following:
Owning a particular stock or asset, providing the cover for selling the call options.
Selling call options on the underlying asset, typically at a strike price higher than the current market value, and with an expiration date of choice.
Covered calls are frequently used as an income-generating tool, as the seller of the call options receives a premium from the buyer. This premium is retained regardless of the price movement of the underlying asset.
Here is a hypothetical example of a covered call and how it looks:
Let’s use John as an investor who owns 100 shares of a company called ABC Nutrition that is trading at $50 per share, the price he paid for his shares.
John decided to sell a call option at a strike price of $55, expiring in a month, and for doing so receives a premium of $2 per share in to his brokerage account, typically the same day.
This translates to $200 income, irrespective of the stock’s performance until option expiration. Sounds great doesn’t it?
Well, this is quite a simplistic view and one you will find written all over the internet, but this strategy is more nuanced than that and to understand covered calls better we need to look at other scenarios if the price of the stock trades around a bit.
So for example, if the shares end up at $55 or higher at expiration date then the call will be in-the-money (ITM) and that means it is likely to be exercised, meaning called away from us (sold).
The owner of the call option will have the right to buy the covered call from John at $55 each. That’s no problem as John originally bought them for $50 and is now selling them for $5 more per share. In other words, John has made a small profit and no loss on ABC Nutrition.
And John does have the $2 premium per share that was paid to him when he sold the covered call.
Here is John’s P&L for this trade
100 shares of ABC Nutrition @ $50 per share = $5,000 total cost
1x covered call sold @ $55 strike price = Total Premium received $200
Shares called away at expiration for $55 = $5,500 + $200 = $700 profit in one month
Why is the gain of a covered call capped?
In this example above it also neatly shows that John’s gain is capped at $7 per share. Even if the shares went to $85 each, John’s gain is simply the $5 per share increase plus the $2 in premium that he was paid for the covered call. The strike price of the call has limited the upside and that is the trade-off we make when we sell a covered call.
There are tools we can use if we want to put the odds in our favour more of not having our shares called away but that is the subject for another article I think. And there are some advanced techniques we can use to buy back our call option that we sold. But for the sake of simplicity this will be discussed in another article.
What happens if the share price drops on a covered call?
Well, in that case, the seller will lose the equivalent amount to the share price drop, but it will be offset to some extent by the premium they received for selling the call in the first place.
So, if the shares dropped from $50 to $45, for example, they would lose $5 on the shares but that would be offset a little by the $2 premium they have brought in.
If we take it to extremes to the shares in ABC Nutrition dropping to $30 each, then the actual P/L for the seller on the whole position would be -$18. And that makes sense, they have lost $20 on the shares but made $2 on the call. Hence a loss of $18, despite the shares dropping $20 from where John acquired them.
The effect of option selling can be seen in the reduction of risk. By selling options, you receive a premium that can help offset any potential loss on the underlying shares. In the example given, a single call premium was received. However, if multiple calls were sold against the position, there would be even more premium to offset any potential loss. In fact, it is possible to accumulate enough premium to completely eliminate any loss on the shares. We will explore this concept in more detail later on.
Here is a real world example of my option trades on T Rowe Price Group Inc, ticker symbol TROW
I entered having a position in TROW from being assigned 2 x cash secured put options in the stock at $118 per share in February 2023. For selling the cash secured puts I was paid $90.
After owning 200 shares of TROW since February I have since sold several covered calls on this stock and earned $2,338 in premiums including picking up $244 in dividend income paid March 30th 2023.
TROW is a Dividend Aristocrat and a company that I am happy to own long term. It also pays an impressive 4.67% dividend.
By selling options on this stock it has allowed me to reduce my cost basis per share to $106.45 (as at 26th May 2023). Remember, I paid $118 per share originally for this stock back in February.
This is the beauty of selling covered calls.
Are covered calls popular in the UK as well as the US?
Being from the UK, I have come to realise that not many UK investors are familiar with options selling. In fact, when I started looking into options I actually thought it was illegal to sell covered calls or cash secured puts at first.
Unlike the UK, US citizens often own their shares for years before selling covered calls on them and this is a great way to juice the annual returns and make some extra monthly income.
What is a buy-write covered call strategy?
A buy-write strategy simply means that you buy your shares at a certain price and then immediately sell the covered calls having established your potential risk and reward based on the current share price. That’s generally known as a buy-write and is the ‘default’ way in which you will often see covered calls discussed. In fact, a number of trading platforms allow you to enter both components as a single trade so that it all executes at once.
Here is a real example of a buy-write strategy in SWK
I recently did a buy-write trade in Stanley Black & Decker Inc, ticker symbol SWK. Stanley Black & Decker are one of the dividend kings and a stock that I didn’t mind owning at the price it was trading at recently, $81.60 per share.
I also noticed that the stock was going ex dividend on the 2nd June, 2023. So by buying 200 shares outright, I would qualify for the next dividend payment and was then able to immediately sell the June 16, $85 strike price covered call pocketing a further $ 289.91.
If the stock finishes above $85 a month from selling my covered call I would have been in profit over $1,000 for 1 month’s work — not bad I am sure you will agree!
Here is a screenshot of my P&L in SWK so far so you can see how I record my trades.
To succeed in option trading you have to run it like you would a business so make sure you get good at bookkeeping. I like to keep a profit and loss tab for every stock I do a trade in. I keep all of these in a google sheet and update it almost daily with new trades.
Which covered calls should you sell?
Well for one, I like the big boring dividing paying blue chip stocks. I don’t like to chase high volatility stocks because of the alluring amount of premium you can receive. Everyone trades according to their own risk tolerance and I want to be able to sleep well at night knowing I own shares in solid reliable companies that have been around for sometimes over 100 years and pay regular dividends.
So let’s start with the assumption that you have done your research, found a stock that you’d be happy to own long term and pulled the trigger and bought them outright or had your cash secured put exercised.
You are now the proud owner of at least 1,000 shares (if trading UK stocks or 100 shares if trading US stocks).
So what happens next?
One major result of possessing this number of shares is the receipt of dividend income. The speed at which this income arrives depends on the upcoming ex-dividend date—it could happen swiftly depending on the stock. Nevertheless, the crucial point is that, provided the dividend remains intact and unaffected, you have successfully obtained a continuous stream of income equivalent to approximately 4% or 5%, or potentially even more.
Currently my highest dividend stock in my options portfolio is 8% from British American Tobacco (Ticker symbol BATS).
By doing nothing more, you now possess a consistent flow of dividend income that can be utilized for expenditure or reinvestment purposes.
However, the true essence of this strategy becomes even more remarkable when you engage in selling covered calls on the shares you have recently acquired. This approach has the potential to generate a substantial amount of additional income while simultaneously allowing you to continue collecting dividends. Furthermore, it presents an opportunity to secure a profit when the shares are eventually sold.
Conclusion: Harnessing the Potential of Covered Calls
Covered calls are a powerful strategy that can provide income and enhance investment returns in the stock market. By understanding how covered calls work, their benefits, risks, and key considerations, investors can make informed decisions and potentially unlock new opportunities for wealth creation. However, it’s essential to remember that no investment strategy is entirely risk-free, and thorough research and careful consideration are crucial when implementing any strategy.
So, why not explore the world of covered calls and see if it aligns with your investment goals? With the right knowledge and diligent execution, covered calls can become an essential tool in your arsenal of investment strategies. Once you acquire this remarkable skill, you can be set for life, constantly earning extra income from the shares that you are happy to own and sell covered calls against.
Don’t let Wall Street fool you into thinking this is an advanced and scary strategy because it isn’t. Once you get familiar with an options chain and start putting on some trades you will soon pick it up.
Best of luck and happy investing!
Read Also: What Is An Options Chain
I put together a list of frequently asked questions I thought people might have after reading this article, hopefully they help refresh some of the points we just discussed above.
Q: What is a covered call?
A: A covered call is an options trading strategy that involves selling call options on stocks that an investor already owns, offering someone else the right to buy their shares at a specified price before a certain date.
Q: How does a covered call work?
A: The investor receives a premium in return for selling the call option, which can act as an additional source of income. If the stock price rises significantly above the strike price, the gain is capped at the strike price.
Q: What are the benefits of a covered call?
A: Covered calls can help protect against small declines in the share price while offering limited protection when the stock price falls significantly. They can be used to enhance returns in a moderately uncertain market while managing potential risks.
Q: What are the risks of a covered call?
A: Covered calls limit potential gains, as the strategy caps the profit received on the shares if the stock price rises significantly above the strike price. They also offer limited protection when the stock price falls significantly.
Q: What are the essential components of a covered call strategy?
A: The essential components of a covered call strategy include owning a particular stock or asset and selling call options on the underlying asset.
Q: How can covered calls be used as an income-generating tool?
A: Covered calls are frequently used as an income-generating tool, as the seller of the call options receives a premium from the buyer.
Q: Are covered calls a popular strategy employed by investors?
A: Yes, covered calls are a popular strategy employed by investors to enhance their overall return on investment (ROI) while mitigating risks. They are not as popular in the United Kingdom than they are in the United States.