Options trading can be a fantastic way to produce an additional source of income. There are a plethora of strategies you can use to do so. Today, I am going to go over one of my favorite strategies to generate additional income, the covered call. I am also going to teach you how you can make your very own covered call trade, and I will go over why you really want to consider doing so! Keep in mind, you will need to fully understand call options to do this. If you do not, check out my article here. If you do not know what options are at all, you may want to check out my article on how to start options trading. Alright, let’s dive in!
What are covered calls?
A covered call is a call option that an investor sells while holding the 100 shares of underlying stock. This option is typically sold at a higher strike price than the market value of the stock. The goal is to produce an income stream through the premium generated by the option. If the option is exercised, you will gain income from the premium. You may also gain income via the difference between the price you paid for the stock and the price it was at when the option was exercised.
I buy 100 shares of XYZ stock at $15 a share. I then sell a call option with a strike price of $17. For selling the call option, I gain $50 from the premium. The stock’s price rises to $18, and the option is exercised. I still get the $50 from the option’s premium, but I also get the difference between the $15 and the $17, $2 a share. So, in total, I actually make $250 from the trade. ($2 a share x 100 shares) + $50 options premium. Pretty cool right?
Now, keep in mind that the stock’s share price could fall or just not move. If it does, the option will expire worthless. You will still get your premium, and you will still have the 100 shares of underlying stock. You can continue to sell covered calls on the stock until a contract is exercised.
How to create a covered call trade
Creating a covered call trade is actually very simple. Here we go:
- Buy 100 shares of your desired stock. 1 call contract is equal to 100 shares of a stock Let’s say you buy 100 shares of XYZ stock at $20 a share for $2000.
- Sell a call option at a strike price above what you paid for the shares of stock. Let’s say you sell it at $23. When you sell the covered call, you will acquire a premium from the contract. Let’s say the premium is $.75 per share.
- Leave the contract open until expiration. This is the simplest way to carry out this trade. You can also buy back the contract in order to collect the difference in premiums if there is any, but I do not want to dive into advanced options trading in this article. If you are interested in learning a little bit about that, check out my call options article here. Anyway, you can hold the contract until it expires or it is exercised. If it expires, you will keep your premium and the 100 shares of XYZ stock. If it is exercised, you will acquire the premium and the difference between the $20 and $23. $300 in this scenario.
Pretty simple right? Now, covered calls do have a some of cons to them. Let’s check it out.
Pros and cons of a covered call
- Little risk to the trade because you hold the underlying stock.
- Great for income generation.
- The trade is fairly passive because you can just keep it open until expiration.
- You could be exercised and you could lose your stock position. This is not necessarily bad if you are planning to sell the stock anyway.
- You can miss out on potential gains. Let’s say the stock from the previous example rises to $25 a share. You will miss out on the additional $125 gain ($200 – $75 premium).
- You underlying stock position could take a dive while you are holding the shares to carry out the contract.
The point of a covered call is to generate income through the premium gained from selling the contract. I favor this trade because you can generate income and keep your underlying stock position if the contract is not exercised. Now, if you are going to start selling covered calls, do not forget about commission fees. They can eat away at your profits, so do not sell contracts that provide terrible premiums. Do you have any question? Feel free to ask in the comment section. Sign up for my mailing list for additional options strategies not covered here! Happy trading!