Mastering The Writing Covered Calls Strategy – Modest Money

The writing covered calls strategy is a solid tactic in options trading, especially appealing to investors who want to increase their income using the stocks they already own. Here’s how it works: you sell call options on your shares, which means you collect a premium upfront.

In return, you might have to sell your stocks at a specific price if the buyer chooses to exercise the option. This strategy not only offers a way to make extra money through premiums but also acts as a safeguard by setting a maximum selling price for your shares.

To really nail this strategy, you need to know how to pick the right stocks and strike prices. This involves analyzing the market carefully and predicting potential price movements. We’re going to look deeper into how to choose these elements effectively to make the most out of the writing covered calls strategy, ensuring it fits well with your overall financial goals.

Key Takeaways

• Earn premium income upfront by selling call options on stocks you already own.
• Cap your upside potential while providing some protection against moderate declines in stock prices.
• Best used in stable or moderately bullish markets where significant stock price increases beyond the strike price are not expected.
• Avoid this strategy in highly volatile markets or when expecting substantial stock price increases, as it may limit profits and increase risks.

What is a Covered Call?

A covered call is a strategy used in options trading where an investor sells call options for stocks they already own. This approach is favored by both professional traders and individual investors to enhance investment income. By owning the underlying stock, the investor has a “cover,” ensuring they can meet the obligation to sell the shares if the option holder decides to exercise their right to buy.

This strategy involves holding a long position in a stock and simultaneously writing call options on the same stock as a way to generate revenue from the option premiums. It’s seen as a conservative strategy because it uses stocks the investor already possesses, providing a safety net since they are not required to purchase additional shares at potentially higher prices.

I’ll guide you through the basics of how this method works and the optimal times for its application to make the most of your investments.

Terms You Must Know Before Understanding Covered Calls Strategy

Before getting into too much detail, I think it is important to cover some terms you must grasp in order to understand covered calls strategy and its application. If you are unfamiliar with any of the following terms, check out my option trading basics article and then return:

1. Call Option: A type of options contract that gives the buyer the right, but not the obligation, to buy a specified amount of an underlying security at a predetermined price (strike price) within a specific time period. The seller of the call, in return, collects a premium from the buyer.
2. Premium: The price that the buyer of the call option pays to the seller. For the seller, this premium represents income received upfront, which is a primary benefit of writing covered calls.
3. Strike Price: The price at which the underlying security can be purchased by the option buyer if they decide to exercise the option. This price is agreed upon when the option contract is formed.
4. Expiration Date: The date on which the option contract expires. After this date, the option can no longer be exercised by the buyer.
5. Underlying Security: The stock or other asset that the option contract is based on. For covered calls, the seller must own the underlying security, as it is required to fulfill the obligation of the call option if it is exercised.
6. Exercise: The action taken by the call option buyer if they choose to buy the underlying securities at the predetermined strike price before the expiration date.

How Covered Calls Strategy Works

Covered Calls Explained: Options Trading For Beginners

In stock ownership, the covered calls strategy presents a popular method for generating additional income. When you write a covered call, you sell a call option on stocks you already own. This transaction involves granting another investor the right to purchase your stocks at a predetermined price, known as the strike price, up until the option expires.

You receive a premium for selling this right, which is yours to keep regardless of whether the option is exercised. This strategy is considered “covered” because you own the underlying stock and can deliver it without needing to purchase additional shares at market price, which might be higher.

When To Use A Covered Calls Strategy

This strategy shines in markets that are expected to be stable or exhibit slight bullish growth. It is ideally employed when you believe that the stock price will rise modestly but not exceed the strike price set by the option.

If the stock price remains below or just at the strike price by expiration, the option expires worthless, allowing you to retain the premium and your shares. But if the stock price exceeds the strike price, the buyer might exercise the option, and you’ll be required to sell the shares at the strike price. This will cap your earnings potential on those shares but still securing the premium and any gains up to the strike price.

This strategy not only allows income generation through premiums but also offers some protection against small declines in stock prices, acting as a cushion against market volatility. I recommend using a quality stock signal provider like Barchart, in order to gain a well-rounded perspective on the market.

Check out my Barchart review to see if this tool can help your trading success.

When To Avoid The Writing Covered Calls Strategy

Writing covered calls is a common strategy used by all types of options traders. That being said, depending on market conditions and your investment approach, it might not always be advisable. If after reading this section you conclude the writing covered calls strategy isn’t for you, consider reading my option hedging strategies article for alternative strategies.

Here’s a closer look at when to step back from writing covered calls:

1. Expectation of Stock Price Surges: If you believe that the stock on which you’re considering writing a call will rise significantly beyond the strike price, this strategy may not be for you.

When you write a covered call, you agree to sell your shares at the strike price, effectively capping your maximum earnings. Any market appreciation beyond this price point will not benefit you, as the stock will be called away at the strike price.

1. High Market Volatility: Covered calls become riskier in volatile markets. The premium you receive does offer some protection against downturns, but this might not be enough if the stock price significantly exceeds the strike price or if it drops sharply.

In scenarios where the stock price shoots up, you might find yourself missing out on considerable profits since you’re obliged to sell at the strike price. Conversely, if the stock plummets, the premium may not fully cover your losses, especially if the stock falls below your breakeven point, calculated as your original purchase price minus the premium received.

1. Long-Term Investment Perspective: This strategy may conflict with long-term investment goals focused on capital appreciation. Selling covered calls can lead to potentially having to offload beneficial stocks that could have yielded higher returns in the future. Furthermore, the ongoing management required for active option trading could distract from a longer-term investment strategy.
2. Lack of Options Trading Experience: Writing covered calls demands a solid understanding of options, including knowledge of premiums, strike prices, and expiration cycles. Newer traders or those not comfortable with the complexity of options might find this strategy challenging.

Misjudgments in timing or pricing could lead to suboptimal outcomes, such as having to buy back options at higher prices, thus eroding gains or exacerbating losses.

Can I Sell The Underlying Stock Before The Covered Calls Expiration?

Sure, you can sell the underlying stock before your covered calls expire, but it’s important to understand the risks involved. When you sell the stock, your covered calls become “naked,” which means you no longer own the stock to cover the call options.

This situation is risky because if the options are exercised, you’d have to buy the stock at the current market price to fulfill the contract. If the market price is above your strike price, you could face significant losses.

Selling your stock transforms a relatively safe strategy into one with potentially unlimited risks, similar to a short sale. So while you technically can sell your stock anytime, it’s usually smarter to close out your call positions first to avoid these high-stakes scenarios. It’s all about managing your risks carefully and knowing when to exit your positions to keep your financial health intact.

Writing Covered Calls Strategy: My Final Thoughts

Mastering the writing covered calls strategy can be a fantastic way to generate premium income while managing downside risks in your stock positions. This options strategy not only helps cap potential losses but also provides an opportunity to earn from your existing stock holdings.

It’s particularly useful when you anticipate moderate growth in stock prices, allowing you to benefit from premium income and potential capital gains up to the strike price.

It’s crucial to recognize when this strategy might not align with your financial goals or market conditions. If you expect significant upward movements in stock prices or face a highly volatile market, the constraints of a covered call might limit your upside potential or fail to provide adequate protection against sharp declines.

For those newer to options trading or seeking alternative strategies that might better suit different market conditions or investment goals, exploring my low risk option strategies article can offer valuable insights and safer investment paths.

By understanding and applying the writing covered calls strategy wisely, you can enhance your investment portfolio’s performance while keeping a check on risks. Remember, continuous learning and adaptation to market changes are key to successful investing.