Welcome to selling covered calls explained. Of all the options strategies an investor and trader can use, selling or writing covered calls probably carries the lowest risk. At the same time, selling covered calls is a straightforward way to use your stock portfolio or your futures account to generate additional income. It is also often seen as an “entry-level” options strategy, probably for good reason.
In summary, when you write covered calls, that is when you sell call options on stocks that you own, you give up your right to gains above the strike price until the option expires. In exchange, you receive the premium payment from the buyer of your call options.
If some of the terminologies here are unclear, this article explains the basics of call and put options.
The classic out-the-money covered call
The usual approach investors and traders take to selling covered calls involves selling just out-the-money calls. You would usually choose a strike price that means the call option is likely to expire still out-the-money. An example will illustrate how this works.
Let’s imagine that you have 100 shares of XYZ company stock in your portfolio. You like the intermediate and long-term prospects for XYZ shares but the market is a little overheated lately and you think it is unlikely that the stock will soar in value just yet.
Let’s imagine that the current share price is $100, looking ahead over the next few months you think it is possible the stock could get to $120 but in light of recent market weakness, you think it is more likely the stock price will stay where it is or pull back a little to maybe $95, or $90.
You look at the options board for XYZ and see that call options with a $110 strike price that are 90 days to expiry carry a premium of $4.50. You can sell this call option and receive $450 cash into your account. Let’s consider what could happen.
The bullish case
Let’s imagine you were wildly wrong on the cautious side and the XYZ stock price climbs by 20% going to $120. The buyer would exercise the option and you get assigned either at or shortly before expiry. You would have to hand over your 100 shares in XYZ and you would receive $11,000 and the cash premium of $450 that you already received.
So you made $11,450 on your $10,000 instead of $12,000. So your return was 14.4% instead of 20%
The bearish case
Now let’s imagine that the XYZ stock price drops by 20% to $80. Your XYZ position is now worth $8,000 plus the $450 that you already received.
You now have $8,450. So your return was a loss of 15.5% instead of a loss of 20%
The graph below shows the expected returns of this strategy vs the XYZ stock price.
What we can see here is that using a covered call strategy in this way, in other words, selling a call that is about 10% out-the-money, works well if you anticipate a movement in the underlying stock price of around 10% either up or down. Actually in this case the breakeven for the covered call happens at an XYZ share price of $114.50
The impact of implied volatility
One of the major determinants of the dynamics of how this strategy works is the implied volatility of the option. The implied volatility is a measure of what the option price tells us options traders think the volatility of the underlying stock will be though to the expiration of the option.
Another way to say that is that when taking into account the strike price, the stock’s current market price, and the time to expiration, the option price implies a degree of volatility in the underlying stock price. Remember that the option price is determined by market demand and supply from options traders. That means psychology and expectations play their part in fixing options prices.
Implied volatility is quoted in percentage and can be directly compared with a standard deviation of volatility in price, when also expressed in percentage terms around the current market price of the stock. Most brokerage platforms that offer options trading will calculate the implied volatility for every option on the board dynamically, i.e. in real-time.
If you watch an options board of a very liquid stock or ETF while the markets are open you will see the implied volatility data changing constantly as trades are executed. The options that are most actively traded and that give the best indication of implied volatility are those that are at-the-money.
The higher this figure is, the more chance the market sees for the option to be in-the-money when it expires. That also means the higher premium a buyer will pay for the option. Which in turn means more premium that you will receive if you sell the option.
Much depends on market conditions of course. If the markets have been volatile for a while that will take time to cool off. You may judge that option premiums and hence implied volatilities are still high. This could be a good time to sell just out-the-money covered calls.
The point here is that the sum you receive for writing an option is the option premium. That is determined by the sentiment of traders about the likely volatility of the price. Your hope is that actual volatility will be less than the market expected and you will just pocket the premium.
The condition that is usually good for writing covered calls is when the market is moving sideways without any significant upward or downward movement.
Image source Power E*TRADE®
An alternative, selling deep-in-the-money covered calls
There is another approach to selling covered call options. From the subheading here I’m sure you can guess it involves selling deep-in-the-money calls for stocks that you own. Let’s take a look at the same example of XYZ stock used above.
This time instead of selling an option with a strike price of $110 and 90 days to expiry, let’s imagine that we sell a call option with a strike price of $70 and still 90 days to expiry. This option would have $30 of intrinsic value and somewhere in the order of $4.50 in extrinsic value, so we would receive $3,450 if we sell such an option.
Let’s consider the same two extreme outcomes.
Deep-in-the-money covered call, the bullish case
So firstly, the XYZ stock price climbs 20% to $120. The option would now be $50 in-the-money. That is relevant to the buyer but since we are the seller we would, certainly at expiry have to deliver 100 XYZ shares for which we would receive $7,000. So our total proceeds would be $10.450 which equates to a return of 4.5% on our $10,000 initial capital.
There is also a possibility we will be assigned before expiry. However, if the buyer does that they would be giving up whatever extrinsic value the option could still be traded for in the market.
Being assigned before expiry can happen and it tends to do so when an ex-dividend date is approaching. If the time value left on the option is less than the dividend then by exercising an option earlier to qualify for the dividend the buyer may choose to give up the remaining time value of the option in exchange for benefitting from the more valuable dividend. This is only possible with American-style options. This article explains the ins and outs of ex-dividend.
Deep-in-the-money covered call bearish case
Then, we consider what happens if the XYZ stock price drops by 20% to $80. The option would be $10 in-the-money, again that fact is of interest to the buyer. As the seller, we would again receive $7,000 bringing our total proceeds to $10,450. So even though the market tanked by 20% our return on capital was still 4.5%.
The graph below shows the outcomes in relation to the market price of XYZ stock at expiry.
Because even with a 20% drop in price the $70 call option is still in-the-money, we don’t see the point where downside risk kicks in. We have to extend the axes and look at a wider range of price movement. This graph illustrates that point
When they work and when they don’t
We can see that while selling deep-in-the-money covered calls eliminates any significant upside potential rewards it is an approach that does offer very strong protection against downside risk. In contrast, selling out-the-money options provides additional income while retaining some upside potential but not reducing or eliminating the downside risk.
The generally accepted wisdom is that it is a good thing to sell out-the-money or at-the-money covered calls in a sideways or slightly down-moving market that may still move up. Essentially what you are trying to do is give up some of the upside potential by accepting a cap on your gains in return for the additional income.
Selling deep-in-the-money calls, in contrast, works best in down markets.
Where are the sweet spots?
What we are seeking to benefit from by selling covered calls is option premium decay. Effectively we would like to sell expensive options with high implied volatility, but then after we’ve sold them the volatility doesn’t materialize. We hope that the option decays and we just pocket the premium.
In practice, it is more usual to sell covered calls closer to the date of expiration, often in the last 20 trading days or so. Much depends on whether implied volatility is rising or falling. If you are fortunate enough to capture implied volatility when it is high, and sell covered calls just before the implied volatility drops then you will reap the premiums without the risks materializing.
We can see that if you are able to lock in just 2 or 3% in premium in the last 20 trading days, that is a very significant annualized return of 28.8% or 42.5% respectively. That would be if you could do it over and over every month, which is, let’s face it, quite unlikely.
Why covered calls may not be a good idea
There is a school of thought that says selling covered calls is not a good idea. The reason we build portfolios of stocks is to benefit from stock price appreciation. If you sell covered calls then you are selling your right to upside price appreciation potential and defeating the purpose of holding stocks in the first place.
The counter-argument is that selling covered calls works if you chose the right conditions.
Periods in the days leading up to earnings announcements or when there is bad news about a company often cause option premiums to rise and implied volatility to increase. Often if you sell covered calls as that happens you will lock in those elevated premiums, and then hopefully just watch them decay to zero as the options expire.
Questions and answers
Q. How much can you make selling covered calls?
A. The theoretical annualized returns on covered calls are high, in excess of 40%. You may get close to that once you become good at it if you learn how to do it well and chose the strike prices and expiration dates with care.
Q. Can you lose money selling covered calls?
A. There are transaction costs, fees, and commissions that the strategy incurs. Also if you do get assigned it will cost you something to get back into your stock position.
Q. What are the downsides of covered calls?
A. The downside of selling covered calls is that you will be giving up the possibility of larger returns. If one of your underlying stocks has a price breakout, you will not be joining in the bonanza.
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