Covered calls add some risk to your portfolio but can be a good way to supplement income. Let’s dig in to understand a bit about options, describe a covered call strategy in detail and identify the risks for an individual investor.
Options
There are 2 main types of options contracts, but for this post, we’ll focus on call options. The other type is called a Put, but we’ll hold on that for now.
Options are contracts between 2 parties. For every option contract, there is a buyer and a seller. As an investor, you could be either.
Call options are contracts that allow the buyer the right, but not the obligation, to buy a certain number of shares at a specified price on, or before a specified date.
Let’s look at an example. Ticker -SBUX240301C96 is a March 01, 2024 Call at $96 per share on Starbucks. Option Ticker symbols have a standard format Dash + Underlying Security Symbol + Expiration Date + Type (C = Call) + Strike Price.
- Underlying security is the security that the call option contract is written against
- Expiration Date is the date on which the contract expires
- A Call option is an option to buy the stock at the specified price
- Strike price is the price at which the underlying shares may be bought and sold
Sample Call Option
If I sell -SBUX240301C96, I am selling another investor the right to buy shares of Starbucks from me on or before March 1, 2024 at $96 per share. A couple additional pieces of info are needed to make this clear.
- Each contract represents 100 shares. Always. If I sell 1 contract, I would be obligated to sell 100 shares at $96, if I sold 5 contracts, I would be obligated to sell 500 shares. In both cases, I would be obligated only if the buyer exercises the option. Exercise means they have opted to invoke the contract.
- Option contracts trade on an open exchange just like stocks and bonds. There is a bid and an ask for every option contract. I sold this option contract on January 29, 2024 for $1.95. This is referred to as the premium. Contract prices are specified as the single share price, however, since we are selling in lots of 100 shares, I received $195 for selling this contract. Pretty cool.
What Happens Next?
2 things could happen:
- The price of Starbucks shares could go above $96, in which case the option buyer would exercise the option. The buyer pays me $9,600 for 100 shares of Starbucks and I deliver the 100 shares. This is all done automatically by our brokers. How thoughtful.
- The price of Starbucks could stay below $96 and the option would expire worthless. I keep the $195 premium.
Covered v. Naked
My apologies to all the teenagers whose search results led them here. This isn’t the good naked.
In a covered call option, the seller of the call buys shares of the underlying security before selling the call option. In the example here, I bought shares of Starbucks in advance at $95.66 per share (total cost $9,566 for 100 shares). In a naked call, the seller sells the option but does not hold shares of the underlying security. For the record, this is risky. More on that to come.
Covered Calls
Let’s look at what can happen with the covered call that I sold.
If Starbucks shoots up to $150 per share between January 29, when I bought, and March 1, the expiration date, I will be hugely bummed. I got my $195 premium, but I lost out on a gain of (150-95.66 = 54.34 x 100 shares) $5,434.00. I bought the shares at 95.66 and sold them at 96, per the contract strike price, so I also got a capital gain of $0.34 per share, or $34, but that is small consolation.
This is the hidden risk of covered calls. As long-term investors, we buy stocks to see them grow. Sometimes stocks do shoot up quickly in a short period of time. By selling a call option, you are capping your upside. You’ve agreed to sell at a specific price, even if the stock goes to the moon.
If Starbucks stays around $95.66, the option expires worthless. I keep the $195 premium and I keep the shares. I can sell another call option for April, or I can hold onto the shares.
If Starbucks drops to 90, or 80, or 70…not a huge deal, as a stock investor with nerves of steel, we expect this. However, don’t expect to sell another April 96 option. Who would buy an April 96 option at $1.95? For the March option, the stock needed to go up only $0.34 from the time I bought the stock and sold the option, to the expiration date. That’s less than 1%. To go from $70 to $96 is more than a 25% move. This is highly unlikely in a month’s time (though possible). Someone will probably buy that option, but they certainly won’t give you $1.95.
Selling Below Purchase Price
And especially, I do not recommend trying and sell a call option at a strike price below the price you paid for the underlying security. I know some will say this is a valid strategy, but it can be easy to get stuck in a cycle where you keep selling options at a lower price point and end up taking a large capital loss. It may feel like you’re making money on the premium, but if you are selling below your cost, you could end up taking a loss on the entire transaction. Brokerage sites don’t always show you this level of information explicitly enough, so it could be easy to lose sight of your entry point in the underlying security.
Risk Re-cap
The 2 key risks for covered calls are:
- Lost opportunity – you miss out on a huge gain. We hold stocks for the long term. We know they can be volatile and it is not surprising to see a stock stay flat for a year or more and then shoot upward, stay flat, or even dip, and shoot up again. While selling options can bring you some extra income, be careful about missing out on the bigger gains that you may need to reach your financial goals.
- Stock price drops. If your stock drops, you may be unable to sell a subsequent covered call on that position for a reasonable strike price. This is OK if you went through the proper analysis and you’re committed to stick with the stock and you’re willing to ride out the low because you believe in your thesis. However, I have made the mistake of buying a stock solely because the call option premium was too great to pass up. It was a company on my watch list, but I wasn’t ready to buy. I saw some things I didn’t like in the financials, but how could I pass up a > 5% premium for a 2 week option? That’s huge. So was the stock price decline over the next 10 days.
Naked Calls
I have never bought or sold a naked call. When I sell a call option, my brokerage flashes a message on the confirmation screen that says “Maximum Loss: Unlimited“. Read that again, Unlimited. Once more: Unlimited. Now, we know that that is not the case on a covered call because I own the shares. But on a Naked call, your potential loss is Unlimited. How could this be?
Let’s say I sold the same -SBUX240301C96 call option, but I did not buy the shares in advance. Starbucks could stay at $95.66, it could go to $100, it could go to $1,000 per share. There is no limit. And since I did not buy the shares in advance of selling the options, when the option is exercised, I will have to buy shares on the open market and deliver them to the option buyer. If I have to pay $2,000 per share for 100 shares, that will cost me $200,000 to buy the shares I am obligated to deliver at a cost of $96 per share. That’s a big loss. And since $2,000 per share is an example, and not the limit, the potential loss is Unlimited.
Enough said about naked calls.
Income Strategy Using Covered Calls
I’ll talk about my strategy in detail. I use covered calls to generate income but I leave the bulk of my investment portfolio in long-term investments which I will not sell options against. To clarify, I only sell options on a very small percentage of my holdings.
First I set a limit for the dollar amount that I will allocate towards generating income through covered calls. This works better with an example.
I am going to allocate $20,000 to generating income through covered calls.
I decide to buy 100 shares of Starbucks at $95 per share for a total cost of $9,500. I sell a covered call with a strike price of $96. I have $10,500 left in my budget so I buy 200 shares of Bank of the Ozarks (OZK) at $42 per share for a cost of $8,400. I sell 2 option contracts for a strike price of $43. I’m close to my limit so I call it a day.
You’ll note that OZK pays a dividend of 3.6% and SBUX pays a dividend of 2.39%. This is an income strategy so I like to choose stocks that meet 3 criteria:
- I am committed and would be happy to hold them for 5 years or more. I need to have a strong thesis.
- They pay a dividend. It’s nice to get a dividend in addition to option premium – stay tuned, more on this below.
- They are less volatile. I had done some covered calls on highly volatile tech stocks. The premiums are high (higher reward, higher risk) but when inflation hit and prices nose-dived, this sunk my strategy for a while.
If All Goes Well
Ideally, I’ll sell options on these 2 stocks and they’ll expire worthless, I take the premium, say thank you and sell another option contract.
Perhaps one or both increase in price and the option is exercised. I keep the premium, sell the stock for a small capital gain, and I then shop for a new stock or 2 to buy and cover within my $20,000 budget.
Or…
My least favorite outcome is that either or both decline significantly. The options expire, I take the premium, but I can’t sell a new contract at a strike price greater than my purchase price because the stock price has declined.
Penalty Box
These stocks now move to the penalty box. This is my own personal term, but what it means is that I am unable to sell covered calls with a strike above my underlying security buy price, but I still want to record-keep the fact that my $20,000 option budget is tied up in these 2 stocks. My budget is based on cost not market value. If these stocks both dropped 50%, then based on market value, I might have some room to buy new stocks, but that is going to cause me to have too much capital committed to options. These stocks will remain in the penalty box until the price rises enough for me to sell an option contract at a strike price greater than the purchase price.
This is why I want dividend paying stocks. I want to be able to collect a dividend while these stocks sit in the penalty box waiting for the price to recover.
More importantly, by sticking to my budget based on cost, the rest of my capital remains in long-term holdings. I expect my long-term holdings to perform similar to the S&P 500, which has gained, on average, 10% per year with dividends reinvested over the last 100 ish years. This is where growth comes from. Putting too much capital toward a covered call income strategy would give me some short term income, but would hurt my potential for long term growth.
Recap
While there is some risk to manage, selling covered calls can be a method of earning income. Be sure to keep detailed records of the purchase cost of the underlying holding to ensure that you are not trading premium payments for a capital loss. The option strategy only works if you are coming out even or better on the underlying stock sale. Also, be aware of the capital committed to this strategy. True wealth comes from long-term buy and hold investing. Don’t trade a few hundred dollars in option premium for thousands of dollars in capital gain potential.
One additional note. Most brokerages do not charge for stock trades, but may charge for option trades. If you are paying trading costs for either, make sure to account for this when calculating the value of an option contract.
All that said, taking a small portion of your portfolio and allocating it to a covered call strategy could net you some solid premiums. Let me know what you think.