Covered Calls

Covered Calls Summary

Selling a call to open a position is a cash generation strategy similar to renting a house.  This strategy is less about stock appreciation and more about a consistent cash flow from your investments.  It’s possible to sell a call option on equities or other calls you own and also to sell against positions you don’t own.   It’s possible to sell a call against a position you own even with limited brokerage trading permissions…usually level 1 or 2.  This type of call selling is known as a “covered” call and is safe enough to do inside your IRA.

For more advanced traders with substantial accounts and a willingness to embrace significant risk, it’s possible to sell calls against positions not owned.  This is known as “naked” call selling and it can be very dangerous.  We’ll spend our time together focused only on selling “covered” call options against positions you already own or purchased specifically for this strategy.

Previously in our call story example, there was a piece of land on a corner in the neighborhood. Let’s say you are the owner of this piece of land. An individual offers you $10,000 if they can buy the property from you for $100,000 in the next 2 years. You think that is a fair price. Either way, if they do or don’t buy the property you keep the $10,000. If they do buy the property, you would receive the $100,000 and you would keep the $10,000.  We will use the land deal as an example of a covered call.

The land is like owning an underlying equity like stocks, ETFs, Futures and even other options which have options available.  Each option contract controls 100 shares of stock, ETF or futures and so a covered call position on these assets requires blocks of 100 shares.  It’s possible to sell one call position against 1 call position already owned.

The person who sells a call to open a position obligates themselves to sell the underlying equity at the strike price listed in the call they sold.  In return for this obligation, they receive a premium of immediate cash flow.  During the life of the call option sold, the seller is under this obligation.

Let’s say the underlying has a price of $53.45 and the owner decides they want to begin generating cash flow.  They have a range of choices of strike prices and expirations dates they can select from; each of which has a different value.  Let’s say the person decides to sell the $55 strike price which expires in 14 days.  Let’s further say this option is currently priced at $1.50.  In this scenario, the seller immediately gets $150 per option contract sold deposited into their account.

If the underlying price stays flat, the option will eventually expire removing the obligation and allowing the person to keep their underlying and the $1.50 they received from the call they sold.  If the underlying price drops $1, the person keeps the full value of the $1.50 premium and also the underlying equity which is now worth $1 less than before but the person has still earned a $0.50 profit.  If the underlying price increases to $55.01 or higher, the person is obligated to sell the underlying at the $55 strike price and forfeits any additional price appreciation.  In this scenario, the person retains the full $1.50 value of the call sold and also gets whatever additional value there might have been in appreciation between the original price of the underlying ($53.45) and the $55 strike price.

In summary, selling covered calls is a way to generate consistent cash flow on equities owned without having to sell those equities or cannibalize the portfolio.  This strategy allows the investor to make money when the underlying goes up, stays flat or even goes down a little bit.  It does limit any appreciation of the underlying to the strike price of the option sold.