Option trading is a mystery to most people, and they don’t want anything to do with it. So when you tell them you want to write covered call options for a living, they think you’re a little crazy.
But it’s good for your portfolio if you understand options and how they can benefit your investing. My goal here is to have covered call options explained for beginners and take that mystery away!
What Is A Covered Call Option?
To understand what a covered call option is, you first need to know what an option is in investing. Put simply, it’s a contract to trade 100 shares of stock at a specified price.
One person wants the ability to buy a stock in the future at a preset price–which is called the strike price. Another person sells them that opportunity for a sum of money, called a premium.
Now the buyer doesn’t get to hold the option to buy the stock indefinitely. It will expire after a predetermined amount of time, which is the call date.
During that time, if the stock goes up, the buyer can exercise the option at any time, and the seller will have to sell the stock at the strike price–no matter how high the stock is at the time.
If the option has not been exercised and the stock is below the strike price by the call date, the option simply expires worthless. The seller pockets the premium, and the buyer is out of luck.
So what is a covered call option?
When an option gets exercised, the seller must sell the stock to the option buyer. If the seller already owns the shares, the trade is covered by the fact that the stock is already in their account. The 100 shares are simply transferred to the buyer. So you have a covered call option.
But investors can sell options on shares of a stock they don’t own yet, which is a naked call option. If the option is exercised, their account will have to buy 100 shares of the stock to be transferred to the option buyer.
Considering that there’s no way of knowing how high the stock price will go, naked call options are much, much riskier, and I don’t recommend them.
Examples of Covered Call Options
Let’s look at some recent options trades that I’ve made:
Example #1 LMND
I bought 300 shares of LMND for $92.70 per share and sold 3 covered call option contracts (100 shares each). The premium I received was $9.34 per share for a total of $2,802. 
The strike price was $95 per share with a call date of January 15th. So the buyer of the contracts had the option to purchase my shares at $95 per share any time before the end of the trading on the 15th–no matter how high the shares went.
As the seller, I had the cost of my shares locked in since I had already purchased them. That is what made the trade a covered call option.
LMND rose in price significantly, and the option to buy the stocks was exercised before the 15th when it hit $160 per share. I pocketed the $2,802 premium plus an additional $690 from the sale of my shares.
The option buyer profited $19,500 minus the $2,802 premium paid to purchase the option.
Example #2 SQ
I bought 100 shares of SQ for $225.89 per share and sold 1 covered call option contract. The premium was $11.92 a share, $1,192.00.
The call date was also January 15th with a strike price of $230. If SQ traded above the strike price, the buyer would be able to exercise the option. I would then have to sell my shares for $230 no matter where the stock was trading at the time.
On January 15th the price of SQ was lower than $230. I retained my shares and kept the $1,192 premium, while the buyer had to take the premium amount as a loss.
Then I was able to write another call for February 19th and start the process over, this time earning a premium of $12.06 a share for $1,206.
Writing covered call options can be very profitable, as you can see. But they are not without risk, so let’s take a look at the risk/reward of this strategy.
Risk/Reward
Writing covered call options is the least risky option strategy there is since you already own shares of the stock. If the share price rises and the option is exercised, the cost of the shares you have to sell is already set.
If you didn’t already own the shares and wrote a naked call option, you’d have to buy the shares at the market price to be able to transfer them to the buyer.
Remember LMND in example #1 above? That stock took off, and if I didn’t already own the shares, I would’ve had to buy them as high as $160 to sell them at the strike price of $95!
Covered calls eliminate the risk of not knowing what price you’ll pay for your stocks. So I leave naked call options to the professionals, and I highly recommend you do as well.
But that doesn’t mean that covered call options are risk free–they’re far from it! Here are 3 of the biggest risks you need to understand before writing options:
Forced To Sell Shares
If you don’t want to give up any of your shares in a company, don’t write covered call options on them. No matter how stable a stock price has been, there’s always a chance that it could rise suddenly.
If that happens, you’ll have to sell your shares. While you can always buy more, it could be at a considerably higher cost than you want to pay.
If you are option trading in a taxable account, you’ll also be liable for taxes on your profit from the sale. Depending upon the price you paid for your shares, the tax bill can negate a good part, or even all, of your profit from the covered call.
Loss Of Potential Upside
One of the biggest downsides is that you give up any gains from price appreciation above your strike price. If your stock doubles in price, you still have to sell the shares for the price agreed to in your option contract.
So, suppose you own a $100 stock that’s been pretty stable, and you decide to juice your returns by writing a covered call option with a strike price of $110.
Then the company reports some great earnings or a new product and suddenly the stock price jumps to $140! Now you’re in the position of having your shares called away at $110 because the option is exercised.
You never know what the stock price is going to do. So if you’re going to write covered call options, you have to be willing to accept that you won’t benefit from any price appreciation above the strike price.
Downside Losses
While any stock can rise suddenly, there’s just as good a chance that it could fall suddenly. Even the best stocks can get a haircut for any number of reasons.
When a stock falls significantly, you can be left with a loss that can be hard to come back from. The original call will lower your cost basis for the stock, and you can keep writing them as long as the price stays below the strike price of the options.
But if the stock bounces above the strike price and the option is exercised, the stock may be called away before you’ve made up your losses.
A good example of this is a call option I wrote on SRPT recently. I bought the shares at $171 and sold January 15th option contracts with a strike price of $175.
Unfortunately, before the call date, this drug maker dropped over 50%, to $82 on bad results from one of its products. There wasn’t any reason to believe that the price would pop back up in the near future either.
The premium I received lowered my cost basis. Then I wrote another set of calls for February 19th with the $95 strike price.
If the stock stays below $95, I can write another one for March, and so on. But if the price recovers above $95, the shares will be called away while my cost basis is still much higher.
While covered call options are much less risky than other options, you always have to be aware that you can suffer significant losses in any trading strategy!
Reasons To Write Covered Calls
There are various reasons why you may want to sell covered call options in your portfolio. Here are some of the most common:
~ Increased returns from your dividend stocks–If you’re like me, you enjoy holding stable, dividend payers. However, as much as I love those quarterly payments, I’m not getting the price appreciation of a growth stock.
So writing covered calls can be a way to get greater returns in addition to those dividends. These types of stocks have lower volatility, which reduces the risk of covered calls. However, the same low volatility also decreases the amount of premium you’ll get.
So be sure that you consider all the costs associated, such as the trading fees and tax implications if not trading in a tax-advantaged account.
~ Looking to sell a stock–Maybe you’ve lost confidence in a company or maybe you’d like to take some profits from a winner that now has an out sized allocation in your portfolio. Whatever the reason, a great way to sell a stock is to write a covered call for every 100 shares you want to sell at the price you want.
If the stock trades above that price and the shares are called away, you’ve gained some extra profit from the premium you received. If it doesn’t, you’ll pocket the premium and can repeat the process over and over until the stock option is exercised.
~ Create a monthly income–I’m a firm buy-and-hold investor and believe it’s the best way to build a lasting retirement fund. However, those who have experience with options and understand the risks can create a full-time income selling covered calls.
Picking the right stocks and having enough assets to overcome inevitable losses is crucial to this type of strategy. So that’s why I believe it takes experience before trying to earn a living from covered call options.
Covered Call Options Are Great For Beginners
If you’re looking for additional ways to build up your nest egg, or, like me, you want to get more out of your assets, covered call options could be just what you’re looking for.
I love getting that extra boost to my returns, and I’m spending the next year refining my strategy to create a full time income. Have you ever written a covered call? Do you think it’s an idea that would work in your portfolio? I’d love to hear your thoughts in the comments below!
