When you buy a stock, do you have an exit strategy? Do you have a target price at which you will sell if the stock rises? If you’re like many investors, you might use a limit order to sell the stock at a higher price, and then wait to see if you get a fill. But there’s another way you may want to consider.
Using options, you can receive money today for your willingness to sell your stock at a higher price. This potential income-generating options strategy is referred to as the covered call.
How it works
1. You own shares of a stock (or ETF) that you would be willing to sell.
2. You determine the price at which you’d be willing to sell your stock.
3. You sell a call option with a strike price near your desired sell price.
4. You collect (and keep) the premium today, while you wait to see if you will sell your stock at the higher price.
Let’s take a look at the possible outcomes from this strategy. If the stock price remains unchanged, you keep your shares and the premium you received from selling the call. If the stock price declines, and the loss is greater than the premium you received, you keep your shares as well as the premium—which only partially offsets the loss associated with the declining value of the stock. Remember, as the owner of shares, you still have all the downside risk associated with the price of the stock. However, if the stock price is above the strike price at expiration, you will be obligated to sell your stock at the strike price, and keep the premium received.
Understanding risk versus reward
Contrary to popular belief, the risk when selling a covered call is not if the stock price were to go higher. Rather, the risk in a covered call is similar to the risk of owning stock: the stock price declining.
There are a few key differences between a covered call and a limit order to sell your stock above the market. First, with the covered call, your effective sell price of the stock is increased by the premium you collect from selling the call. Second, if the stock price doesn’t increase to your desired sell price, with the covered call you will still collect a premium. However, if the stock were to rise above the strike price, your profits with the covered call are capped at that price.
This chart compares the possible outcomes from selling a covered call with owning stock alone:
|Stock price||Stock alone
||More profitable outcome|
|Goes up a lot
||Unlimited gain||Limited gain up to strike price, plus premium received
|Goes up a little
||Small gain, plus premium received
|Stays flat||No gain||Premium received
|Goes down||Loss||Loss minus premium received
Notice that in three of the four outcomes, the covered call comes out the winner. In the scenario where the stock price drops significantly, with the covered call some of the loss is offset by the premium you keep from selling the call.
Let’s assume stock XYZ is currently trading for $72 per share. You would like to sell 200 shares if it rises about 10% to $79. You could place a good-til-canceled (GTC) limit order to sell 200 shares at $79 and wait to see if you sell your shares. Or, you could sell two XYZ options contracts with a $79 strike price at a $1.50 premium and collect $300 (2 X $1.50 X 100 = $300 minus commission) on your willingness to sell your 200 shares at $79. By selling the covered call, you will generate income in your portfolio by collecting premiums for your willingness to be obligated to sell your stock at a higher price.
Once you sell a covered call, you do need to monitor your position. It is important to note that you do not need to wait until expiration to see what happens. You can always unwind, or close, your options position before expiration. Just because there’s an expiration date attached to the options trade, it does not mean you have to hold it until that date. If the trade is profitable and you want to take your profits earlier than expiration, then do so! Conversely, if you experience losses on the trade and you want to limit further losses, you can always close the trade.
The covered call is a flexible strategy that may help you generate income on your willingness to sell your stock at a higher price. Open an account to start trading options or upgrade your account to take advantage of more advanced options trading strategies.