KEY POINTS
"Covered calls" are a way to generate constant income on your long-term stock holdings with zero risk of additional loss.
You earn income by selling call options.
The calls are "covered" because you already own the stock, so if the calls are exercised, you don't need to buy stock on the open market to cover them.
The only risk of loss is the risk from owning the stock itself.
However, if this is an existing long-term position for you, that is a risk you are taking on regardless.
Covered calls simply allow you to earn extra income while you hold, with no additional risk required.
If you love dividends, you will love covered calls even more.
Covered calls allow you to generate constant income (every month!), without taking on additional risk of losses.
Covered calls are a three-step process:
- Owning a stock
- Selling call options on that stock
- Waiting for the options to play out (then repeat!)
Step 1: Owning the stock
Covered calls work best when you have a stock that isn't volatile.
A boring company like Coca Cola, Citibank, Kelloggs - something like that.
These are companies that don't go through wild swings, and just move up slowly over time, which is ideal for selling covered calls.
However, the strategy I'm about to show you can work with any stock you intend to hold long term.
Also - it's important to note you must be okay with selling this stock (at a profit).
If this is a stock position you wish to hold forever and never want to sell, it's not a good choice for the covered call strategy.
This is because you may be required to sell if the calls expire "in the money" (will explain below).
Step 2: Selling call options
Covered calls work best when you have just bought the stock, or the stock has gone up since you bought it.
As I write this, Apple stock is trading at $185 per share.
Let's say we own 100 Apple stock which we purchased for $175 per share (meaning we're already up $10 per share).
The next step is to sell call options on our stock.
Refresher - a call option gives the owner the right (but not the obligation) to buy a stock at a future date at a specific price.
You can both buy and sell call options.
For example, if you bought a "December 31 Apple $200 call" it would give you the right to buy Apple stock at any time before December 31 for $200 per share.
Similarly, if you were the seller of that call option, you will be on the other side of that transaction (i.e. you would be required to sell Apple stock to the option holder for $200 at any time they choose before December 31).
Read my article on options for a refresher.
In this scenario, we are in a great position because we are already in a $10/share profit on our holding (we bought Apple for $175, and it's trading for $185.
Let's take a look at the options chain.
Marked in green is a possible option here to sell a covered call.
Remember - options are sold in groups of 100, so selling "one" call option contract will be for 100 shares.
Let's break this down:
Highlighted in green you can see the option we plan to sell:
- Call option on Apple (AAPL)
- Strike price $190
- Bid price $1.60
- Expiry 27 days
This means we can sell call options for $1.60 per share, and the buyer of those options will then have the right to buy Apple stock from us for $190 per share, at any time within the next 27 days.
Because the bid price is $1.60 per share, and every call is for 100 shares, the buyer will be paying us $1.60x100 = $160 for these call options.
Cha-ching!
Step 3: Watching the options play out
We've now got $160 in the pocket.
The final step is watching the options play out to their expiry date.
The position we will be left in depends on how the stock price moves.
Let's go through each scenario:
Apple stock stays below $190
If Apple stock stays below the strike price of $190 until the expiry date, the options will never be exercised and will expire worthless.
This is good for us - we received $160 for the options, and we have no obligations.
Just continue holding our Apple stock like we were doing anyway (and sell covered calls again!)
End result:
Your loss: nil
Your profit: $160
Apple stock goes above $190
If Apple stock goes above $190, it is likely the options will get exercised by the holder.
This means you will be obligated to sell your Apple stock for $190 per share.
This doesn't result in a loss though - remember you bought the stock for $175 per share, and now you're selling it for $190 per share - a $15 per share profit on 100 shares, or $1,500 in total.
This is why the calls are considered "covered". Because you already own the stock, if the calls get exercised, you don't need to buy stock on the market to cover your obligation. You're already covered by your existing holdings - just sell the stock you already own.
In this scenario, your end result will be $160 profit from selling the calls, plus $1,500 profit from the sale of your stocks.
End result:
Your loss: nil
Your profit: $1,660
So you can't lose money? Where's the catch!?
The two "risks" that covered calls are considered to have are:
Risk #1:
While you can't lose money per se on the option itself, you can lose out on potential profit.
For example, let's say Apple stock rises to $200 per share before your calls expire.
That means you are now obligated to sell your stock at the strike price of $190, even though they're worth $200.
You bought the stock for $175, so your profit from selling the stock for $190 will be $1,500.
Selling them on the market for $200 would have netted you profit of $2,500.
You would "lose" out on profit of $10 per share, or $1,000.
Risk #2:
The second "risk" with a covered call is simply that you need to own the stock.
This means you take on the risk of being a shareholder, and you could potentially lose your money if Apple goes bankrupt or performs badly.
However, this is a risk you were taking on anyway.
You don't take on any additional risk by selling the covered call.
Why I Love Covered Calls
Remember what we learn from the great investors - good investing is about preservation.
It's not about maximising your upside, but minimising your downside.
If there is a way for you to make even a single dollar without any risk, you should take it!
This is the reason I like covered calls.
While technically there are "risks", I don't consider either of these "risks" outlined above to be actual risks.
Whether I sell covered calls or not, I would own my stocks anyway, and will be happy to own them for the rest of my life.
Therefore, the "risk" of being a shareholder isn't relevant to me when selling a covered call, since I take on that risk regardless (selling covered calls actually decreases your risk of owning stock, since it's providing you with additional income).
The second "risk" of making less profit is also something I don't consider a risk, because there's no risk of actual loss.
Selling a stock for a $1,500 profit instead of a $2,500 profit shouldn't be considered a "loss" by any investor, because you didn't lose anything. You made a profit! Not to mention you took on far less risk in the $1,500 scenario.
If you're a long term investor, with confidence in your existing stock holdings, selling covered calls contains no additional risk.
It's a way to generate additional income risk-free.
This makes covered calls one of my favourite blue arrows (even better than dividends!)
It's important to note, however, I have core holdings in my portfolio that I won't sell covered calls on, because it's a stock I have no interest in selling and wish to hold forever.
However, I also have holdings that I don't really mind selling, and those are the ideal candidates for covered calls.
Here's a real example from my portfolio:
Example: Covered calls on JD
A while ago I purchased stock in JD.com.
I bought JD because it's a solid company that I thought was trading far too cheaply. It has billions of cash in the bank and will not be going bankrupt. It's like the online Walmart of China. It pays a dividend. I got it at a price I believe was a bargain and I'm happy to hold this long term.
However, it's not really a company I'm dying to own for 30 years.
I'd be happy to sell it and take profit on it any time.
You can see I bought the stock for $37, and I'm up a couple hundred dollars on it already ($239):
This is the perfect scenario to sell covered calls.
Here you can see I've sold a 40 day call at a strike price of $43:
The calls were $1.23 each, so I received $123 USD in total.
Now - what are the possible outcomes?
JD price goes up to $43 - calls get exercised and I need to sell my stock. I bought the stock for $37, so at the strike price of $43 I will make $6 profit per share, for a total profit of $600. I also have the $123 from selling the calls. Total profit $723.
JD price stays below $43 - calls expire worthless. I keep my $123 and my JD stock (and sell covered calls again!)
In summary - I don't really care what happens!
The price can go up or down.
I will just keep collecting a few hundred dollars by selling calls every month until the stock goes up to the strike price of $43, at which point it will get sold (for a profit).
Note: If the stock does reach the strike price, I also have the option to simply buy the call options back, if I change my mind and don't wish to sell the stock.
If the stock tanks, I will just ride it through like I would have done with any other stock in my portfolio (in fact I'll probably buy more).
Like I said, JD is a fundamentally a great company - I wouldn't have bought it otherwise. Unless that changes there'll be no reason for me to sell it (and you only lose when you sell).
Until then, covered calls will keep refilling the bank.
Limitations to covered calls
The main limitations we have already talked about:
- You must own the stock and be willing to sell the stock. If the calls expire in the money, you will be legally obligated to sell.
- The stock must be trading near or above where you bought it. If you bought the stock at $200, you want to sell your covered call above a strike price of $200. That won't be possible if the stock has tanked down to $100.
The final limitation we haven't yet talked about it is the capital required.
Remember - options contracts are for 100 shares, so you must own at least 100 shares to sell a covered call.
Currently Apple trades at $185 per share, meaning you would need to hold 100 shares of Apple, or $18,500 worth, if you want to sell covered calls.
If you don't have that much capital, you would need to limit your covered calls to lower priced stocks.
How Can I Sell Covered Calls?
I use Interactive Brokers for all my non NZ/AU investing.
Interactive Brokers allows you to buy and sell options, among many other instruments, and has some of the lowest fees in the world.
They're ideal for selling covered calls, especially on US stocks.
If you would like to start using Interactive Brokers, you can get up to $1,000 in free stocks when you sign up using my referral link!
You can also read my full review of Interactive Brokers here.
