Covered Calls: Turn Your Shares into an Income-Generating Machine

Call Options. Many have no clear idea of what they are. Some use them as mechanisms to gamble, few know how they work, and even fewer know how they can be used properly. The common claims surrounding call options can entice even the smartest, most level-headed investors into an emotional, ‘hopeium’-fueled mistake of a position. Phrases and buzzwords like ‘Unlimited profit potential with minimal risk’ or ‘Why settle for 10% a year when you can make [insert ridiculous %] in a month?’ are used to appeal to those who confuse Wall Street and Las Vegas.

There is a place for these products, and there is a right way (maybe not “right way,” but a better way) to use them. Instead of buying call options and subscribing to the “me, my call option, and a dream” method, what if we could utilize the strategic (I cannot stress this enough) sale of call options? As the saying goes, “During a gold rush, sell shovels.” And selling ‘covered calls’ could be just what the doctor ordered.

Before diving into covered calls, let’s quickly review what a call option is (feel free to skip ahead if you’re already familiar). For those unsure what a call option entails, here’s a brief explanation with links to additional resources below.

Quick Overview: Call Options

Call options, one of the two primary types of options contracts, grant the buyer of the call the right—but not the obligation—to purchase 100 shares (a standard contract size) of an underlying stock at a predetermined price (the strike price) before or on a specific expiration date.

A call buyer may purchase the contract for a number of reasons, including speculation on an increase in the stock price, hedging a short position in the underlying, etc. The buyer of the call pays a ‘premium’ for the contract, which represents the cost of this ‘right to buy.’

The seller (or writer) of a call option takes on the potential obligation to sell the underlying stock at the strike price if the buyer exercises the option. In exchange for this obligation, the seller collects the premium paid by the buyer. If the stock price remains below the strike price by expiration, the call expires worthless, and the seller keeps the premium without further obligation. If the underlying’s price rises above the strike price, the holder (buyer) of the call could ‘exercise’ the call, the seller would be ‘assigned’ and would then have to sell 100 shares to the buyer at the predetermined strike price.

For more info, I have included some helpful links on the basics of options, specifically call options. You can also check your brokerage’s educational resources, since most platforms have a course or program dedicated to options.

What is a covered call, and why should I care?

Well, Most of us have stock positions in our investment accounts that we have been trying to exit for quite some time, and have not for whatever reason (attachment, effort avoidant, FOMO (Fear of Missing Out) of potential future gains, tax implications, etc). Before you know it, you have held a ‘luke-warm’ stock for years, or even decades. You may occasionally receive a small dividend, but it is likely not substantial and would not justify holding an underperformer.

By incorporating covered calls, we will receive premiums for selling the call contracts and enter into a potential obligation to sell the underlying at a slight premium to the current price. This strategy typically works best if you’re neutral to slightly bullish on the stock, as you can earn income without needing a big price increase. If done properly, however, this can be set up to where you don’t really care if the stock moves up, down or stays the same (within reason, extreme movements can muddy the waters).

Another attractive aspect of covered calls is that they capitalize on time decay (theta). As the option nears the expiration date, its value naturally decreases. All else equal, the premium required to close your covered call position (we ‘sold-to-open’ and could ‘buy-to-close’ before expiration) gets cheaper and cheaper as we near expiration. It's a strategy where time works in your favor, a principle we are huge proponents of at ThetaThrottle.

If this was a lot of information, stay with me. I will break it down in a super simple example below:

This is Dude.

Dude owns 100 shares of XYZ stock and has not been super thrilled with its performance in the past 2 years. It is currently January 1, 2025, and XYZ is sitting at $25/share. Dude would love to sell the stock if it were to rise to $30/share.

Since Dude is subscribed to our free newsletter, he is aware of covered calls and decides they are the right fit for his situation. So, he decides to sell a call option with a strike price of $30/share and an expiration of January 31, 2025. He receives a premium of $100 (Remember, contracts are for 100 shares; $1 per share x 1 contract (100 shares)=$100) from the call buyer (Lady). Dude is now potentially obligated to sell 100 shares of XYZ at $30/share through expiration.

Dude sets aside his 100 shares of XYZ in case he is assigned and goes on about his life. The 100 shares of XYZ will continue to collect any dividends that are paid while he owns the underlying.

There are two outcomes that could happen to Dude at expiration on January 31st.

Outcome 1: XYZ Remains Below $30/Share

Option 2: XYZ Moves To or Above $30/Share

Both scenarios move Dude toward a desired outcome of either generating extra income or selling the underlying at the desired price.

Nothing in finance (or life, for that matter) is a total win-win, so what is the catch? A simplified answer would be ‘extreme movements’ in the share price. If the stock moves upward substantially to $50/share, Dude would be obligated to sell at $30/share and is likely going to be disappointed at the missed additional gains. Also, if the share price decreases to $10/share, he still owns the underlying and would be affected by the drop-off in price.

It’s important to note that, like any options strategy, covered calls come with nuances to consider. For example, there’s the ability to roll your position—extending the time frame or adjusting the strike price—to potentially improve outcomes. Taxes are another factor, as premiums are generally taxed as short-term capital gains. Depending on how long the underlying was held, the capital gains from the sale may be taxed at ordinary (typically higher) or capital gains rates (typically lower; underlying must have been held for at least 1 year and 1 day).

Additionally, while commissions are low with many brokers, they can still chip away at your profits over time. Investors should also consider potential assignment risks if the stock price exceeds the strike price before expiration, as well as account requirements and margin implications depending on your broker. Understanding these details is extremely important before selling a covered call (or entering any options position, for that matter).

How Do I Start?

Review your portfolio for stocks you wouldn’t mind selling at a specific target price. Once you’ve identified the stock, check your brokerage platform’s options chain to see the premiums available for call options at different strike prices and expiration dates.

But before you dive in, make sure you thoroughly understand the risks and mechanics of covered calls. Consider starting with a simulated trading account (‘paper money’) to practice and refine your approach. Educational resources on options trading are invaluable for grasping the strategy's nuances and maximizing its benefits, and most brokerage platforms offer these resources for free.

It’s important to recognize that everyone’s financial situation is unique. While covered calls can be a powerful tool, they may not suit every investor's goals or risk tolerance. Consult a financial advisor if you would like specific guidance or tailored advice, an assessment about whether covered calls align with your broader financial plan, and help understanding the potential tax implications or other nuances specific to your portfolio.

All things considered, getting started with covered calls is fairly straightforward. For more strategies, insights, and helpful guides, subscribe to our free weekly newsletter. Join our community and take control of your financial journey today!

Disclaimer

The information provided in this newsletter is sourced from reliable channels; however, we cannot guarantee its accuracy. The opinions expressed in this newsletter are solely those of the editorial team, contributors, or third-party sources and may change without prior notice. These views do not necessarily reflect those of the firm as a whole. The content may become outdated, and there is no obligation to update it.

This newsletter is for informational purposes only and does not constitute personal investment advice. It is not intended to address your specific financial situation and should not be construed as legal, tax, or accounting advice, or as a recommendation to buy, sell, or hold any securities. No recommendation is made regarding the suitability of any investment for a particular individual or group. Past performance is not indicative of future results.

We strongly advise you to consult with a financial advisor before making any investment decisions, including determining whether any proposed investment aligns with your personal financial needs.