Writing Covered Calls

Writing a covered call means you’re selling someone else the right to purchase a stock that you already own, at a specific price, within a specified time frame. Because one option contract usually represents 100 shares, to run this strategy, you must own at least 100 shares for every call contract you plan to sell.

As a result of selling (“writing”) the call, you’ll pocket the premium right off the bat. The fact that you already own the stock means you’re covered if the stock price rises past the strike price and the call options are assigned. You’ll simply deliver stock you already own, reaping the additional benefit of the uptick on the stock.

Here’s how you can write your first covered call

First, choose a stock in your portfolio that has already performed well, and which you are willing to sell if the call option is assigned. Avoid choosing a stock that you’re very bullish on in the long-term. That way you won’t feel too heartbroken if you do have to part with the stock and wind up missing out on further gains.

Now pick a strike price at which you’d be comfortable selling the stock. Normally, the strike price you choose should be out-of-the-money. That’s because the goal is for the stock to rise further in price before you’ll have to part with it.

Next, pick an expiration date for the option contract. Consider 30-45 days in the future as a starting point, but use your judgment. You want to look for a date that provides an acceptable premium for selling the call option at your chosen strike price.

As a general rule of thumb, some investors think about 2% of the stock value is an acceptable premium to look for. Remember, with options, time is money. The further you go out in time, the more an option will be worth. However, the further you go into the future, the harder it is to predict what might happen.

On the other hand, beware of receiving too much time value. If the premium seems abnormally high, there’s usually a reason for it. Check for news in the marketplace that may affect the price of the stock, and remember if something seems too good to be true, it usually is.

There are three possible outcomes for this play:

Scenario 1: The stock goes down

If the stock price is down at the time the option expires, the good news is the call will expire worthless, and you’ll keep the entire premium received for selling it. Obviously, the bad news is that the value of the stock is down. That’s the nature of a covered call. The risk comes from owning the stock. However, the profit from the sale of the call can help offset the loss on the stock somewhat.

If the stock takes a dive prior to the expiration date of the call, don’t panic. You’re not locked into your position. Although losses will be accruing on the stock, the call option you sold will go down in value as well. That’s a good thing because it will be possible to buy the call back for less money than you received to sell it. If your opinion on the stock has changed, you can simply close your position by buying back the call contract, and then dump the stock.

Scenario 2: The stock stays the same or goes up a little,but doesn’t reach the strike price

There’s really no bad news in this scenario. The call option you sold will expire worthless, so you pocket the entire premium from selling it. Perhaps you’ve seen some gains on the underlying stock, which you will still own. You can’t complain about that.

Scenario 3: The stock rises above the strike price

If the stock is above the strike price at expiration, the call option will be assigned and you’ll have to sell 100 shares of the stock.

If the stock skyrockets after you sell the shares, you might consider kicking yourself for missing out on any additional gains, but don’t. You made a conscious decision that you were willing to part with the stock at the strike price, and you achieved the maximum profit potential from the strategy.

Pat yourself on the back. Or if you’re not very flexible, have somebody else pat your back for you. You’ve done well.

The recap on the logic

Many investors use a covered call as a first foray into option trading. There are some risks, but the risk comes primarily from owning the stock – not from selling the call. The sale of the option only limits opportunity on the upside.

When running a covered call, you’re taking advantage of time decay on the options you sold. Everyday the stock doesn’t move, the call you sold will decline in value, which benefits you as the seller. (Time decay is an important concept. So as a beginner, it’s good for you to see it in action.)

As long as the stock price doesn’t reach the strike price, your stock won’t get called away. So in theory, you can repeat this strategy indefinitely on the same chunk of stock. And with every covered call you run, you’ll become more familiar with the workings of the option market.

You may also appear smarter to yourself when you look in the mirror. But we're not making any promises about that.

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