In the last two years, options trading volumes have reached new heights
This is due to historical volatility and the rise in mobile brokerages.
You might be curious about which strategies work best for you if you are new to options trading or thinking of getting started. The covered call is a simple type of option trade.
What’s a covered call?
Covered calls are options trading strategies that involve selling (also called “writing”) call option options on stocks you own in order to collect the option premium.
Let’s say you have Amazon shares and are looking to make passive income. Amazon does not pay dividends but you can sell call options on shares and have those options remain unexecuted. You’ll get a “dividend like” payment for the option sales without having to do any work in return.
Although selling a covered-call has all the risks of any investment strategy, it is generally viewed as a conservative option that investors are looking for more income.
We’ll explain covered calls in simpler terms by explaining some options terminology.
Options are tradeable contracts that can be traded and whose value depends on the stock’s price. There are two types: calls and puts.
You pay a small amount (the “premium”) to buy a stock. In return, the stock will be purchased at a fixed price (the strike price) on or before a certain date (the”expiration).
A put purchase is similar to buying a stock option, but it allows you to sell the underlying stock at strike price before or on expiration.
Calls can be profitable for buyers, or “in-the money”, when the market price for the underlying stock exceeds the strike price. This is because exercising the option to buy the stock at strike price would result in the stock being less valuable than its actual value.
Buy when the stock is trading below its strike price. This is because the option could be a profit for the buyer, as it would mean that the stock will be sold for more than it’s worth.
Puts and calls have more than buyers. They also have sellers.
If you sell a call you receive the premium from the buyer. In exchange, you are obligated to transfer the strike price to the buyer if the buyer chooses to exercise their option before expiration.
Call sellers hope that this doesn’t happen. If the option is in the money and the buyer exercises it then the seller must give the stock to them for less than its value. If the option is out-of-the money and the buyer does not exercise it, the seller will keep the premium but no action.
The market participants in the four options markets and their incentives
Covered or naked call selling
To sell calls on a stock, you don’t have to own it. This is known as naked call selling and can be a risky way to place bets against underlying stocks.
Most brokerages will only allow experienced investors with margin to trade naked calls. This is because the naked call seller must have the ability to purchase the stock immediately at market price and then deliver it to the buyer in the event of a trade going against them.
A covered call is selling a call on stock you own. A covered call does not necessarily have to be against the stock. It can also generate additional income from stock holdings.
What is a Covered Call Strategy?
Covered call strategies typically involve selling out-of the-money calls on stocks you own (calls where the strike price exceeds the market price).
If the market price remains below the strike price, you can keep the premium and the stock. You get the stock for free, but you lose the option.
If the strike price rises above the market price and the buyer exercised the call, you will still get the premium but must sell the stock at the strike price to the buyer. The sale would still be profitable, as the strike price is generally higher than the price you paid for the stock. However, it would be less profitable that selling at the market price.
The upside to a covered call strategy? You could get a premium for just owning stock. However, you could miss out on profit above the strike price.
Covered Call ETFs
Investors interested in covered calls strategies but not wanting to deal with options trading might want to look at covered call .
Covered Call ETFs usually invest in a stock index, such as the Nasdaq 100 and the S&P500 . Then they sell calls against the index to generate additional income.
They don’t always achieve this goal. Some S&P 500 covered-call ETFs yielded lower than other S&P 500 ETFs at the time of publication.
Covered-call ETFs often have higher expense rates than those that do not track the same index.
Selling covered calls
Selling covered calls can theoretically increase your stock returns by generating income from stocks with low growth rates. It’s not without risk, and it may not be an ideal replacement for traditional buy-and-hold investments strategies.
The London Business School conducted a 2022 study that examined the returns of U.S. retail option trades from 2019 to 2021 and tracked their average returns over a range of time periods. The average retail options trader lost money over all time periods.
While options-trading strategies such as covered calls can make you money, most investors aren’t.
The S&P 500 index returned an average of 10% per year over the past century. The index has performed better in some years than it did in others.
All investors who have an S&P 500 ETF or index fund over a certain time period will receive the same return. The steady 10% annual return will be closer to what they have been earning the longer they keep it.