One of the many benefits of trading stock options is that the possibilities for how you can make money are so abundant. There are also a variety of options risk management strategies you can employ to protect yourself from losses. 

Today, we’ll introduce a unique strategy that allows you to maximize profits while covering your existing positions in a given stock – covered calls options. So, what are covered calls options?

In essence, covered calls involve holding a long position in a stock while selling call options on the same stock to generate additional income. We’ll talk more about why this can be a powerful tool in your arsenal and how to start selling covered calls yourself. 

You’ll also learn how our stock analysis software here at VectorVest eliminates all the guesswork, emotion, and human error from investing, empowering you to earn higher returns with less work and stress! Get a free stock analysis for a buy, sell, or hold recommendation on any given stock today.

What Are Covered Calls Options?

So, what are covered calls options? Covered calls options are a strategy in options trading where an investor holds a long position in an asset and sells call options on the same asset to generate income. 

This approach is “covered” because the investor owns the underlying asset, which provides the cover or security for the call options sold. The goal is to earn premium income from the sale of call options while potentially benefiting from the appreciation of the underlying asset.

How Does it Work?

    • Purchase or Own the Underlying Asset: You need to already own shares of the underlying stock. For every 100 shares, you can sell one call option contract.
    • Sell Call Options: It’s important that you understand the differences between call vs put options. The call option gives the buyer the right, but not the obligation, to purchase the underlying asset at a predetermined strike price before the option expires.
    • Collect Premium: The premium is the income generated from the covered call strategy, which is paid by whoever buys your options contracts. 
  • Outcome at Expiration: So, what happens when options expire? If the stock price is below the strike price, the options expire worthless. You keep the premium from the contract sold along with your shares of stock. On the other hand, if the stock price is above the strike price, the call options are exercised. You’ll have to sell your shares at the strike price, foregoing any additional gains you would have made.

So, the outlook you’d have when selling covered calls is that the stock’s price is going to remain relatively unchanged – or, at least not rise above the strike price. This is how you make money selling covered calls. We talk more about this in our guide on when to sell options.

There are a lot of nuances when it comes to stock options for beginners, which is why we suggest a few more resources before you consider trying this strategy:

In the meantime, let’s look at an example of this strategy for a clearer understanding of how covered calls work.

Example of a Covered Call Option Play

Let’s say you own 100 shares of Company XYZ, currently trading at $50 per share. You decide to sell a covered call option with a strike price of $55, expiring in one month, and receive a premium of $2 per share. Here are the two potential outcomes:

  • Stock price remains below $55: The call option expires worthless, and you keep the premium of $200 (100 shares x $2). You still own the 100 shares, which you can continue to hold or sell more call options.
  • Stock price rises above $55: The call option is exercised. You sell your 100 shares at $55 each. You keep the $200 premium plus an additional $500 from the stock appreciation ($55 – $50 x 100 shares).

You can probably see why this is a powerful stock investment strategy, but is it right for you? Let’s look at the advantages and disadvantages below.

Is the Covered Calls Options Strategy Right For You?

Selling covered calls is always going to be a gamble to a certain extent, as you don’t know with 100% certainty what a stock’s price is going to do in the future. 

Sure, you may have industry or company insights that allow you to make a more educated guess, but at the end of the day, it’s just that – an educated guess. 

So, you need to understand not just the upside but also the downside of selling covered calls.

Advantages

  • Premium Income: This can provide a steady stream of additional cash flow, which can be particularly appealing in flat or slightly bullish markets.
  • Downside Protection: The premium received provides a small cushion against a decline in the stock price. While it won’t fully protect against significant drops, it can mitigate minor losses.
  • Enhanced Returns: You can potentially improve your overall returns by collecting premiums, even if the stock price remains relatively flat. This leads to a better total return compared to holding the stock alone.
  • Adjustable Strategy: Covered calls can be tailored to match your market outlook and risk tolerance. For instance, selecting different strike prices and expiration dates can adjust the level of risk and potential return.

Disadvantages

  • Cap on Gains: If the stock price surges above the strike price, you must sell the shares at the strike price, missing out on any additional gains. This cap on potential profits can be frustrating in a rapidly rising market.
  • Forced Sale: If the stock price exceeds the strike price, the call option will likely be exercised, and you’re forced to sell the shares. This could result in the sale of stocks you wanted to hold long-term, causing you to miss out on dividends or other secondary benefits of ownership.
  • Stock Decline: While the premium provides some downside protection, it won’t cover significant losses if the stock tanks. You still bear the full risk of holding the underlying stock.
  • Complexity: In comparing stocks vs options in general, there’s a ton of nuance and moving parts associated with options trading. It’s not something we recommend to beginners, and even seasoned traders can find themselves overwhelmed.
  • Tax Implications: Covered calls are typically taxed as short-term capital gains, which may be taxed at a higher rate than long-term gains. Capital gains taxes apply to any profits you earn upon selling shares, too. Learn more about taxes on options trading in our blog.

Getting Started Selling Covered Calls

If after reading through the pros and cons you decide you’re interested in learning how to sell options, great! We’ll walk you through everything you need to know to take the first step with confidence below.

Understand Your Goals and Risk Tolerance

Are you looking for additional income, a hedge against market volatility, or both? This strategy works best if you are comfortable potentially selling your shares if the stock price rises above the strike price. 

Select the Right Stocks

We have a thorough guide on how to find stocks for options trading, but just remember to choose stocks you already own and are willing to sell if the call options are exercised. 

Ideal candidates are typically stable, blue chip stocks with relatively low volatility. These stocks should have a track record of steady performance and dividends. You also need to own at least 100 shares to fulfill the call contract.

We’ll talk more about this later on, but you can also use VectorVest, the best stock picker, to help you find winning opportunities. Part of what makes it the best stock analysis app is that you can analyze a stock’s price trend and get a better understanding of the direction it’s moving in.

This way, you can formulate more favorable options contract terms to set yourself up for success in selling covered calls. Speaking of which…

Decide on the Strike Price and Expiration Date

As we briefly touched on earlier and you may already know,the strike price is the price at which you agree to sell the stock if the option is exercised. The expiration date is the date the option expires. These are the two most important levers in building favorable contracts as a seller.

Choose a strike price that reflects your willingness to sell the stock. A higher strike price offers less premium but more room for stock appreciation. Similarly, shorter expiration dates (weeks to a few months) provide more frequent opportunities to sell calls and collect premiums.

There’s a balance to be struck here between risk and reward. If you’re risk-averse, that’s fine – just know you won’t earn nearly as much as if you took a more aggressive outlook.

Calculate the Potential Premium

The premium is the income you receive for selling the call option. It’s influenced by the stock’s volatility, the time until expiration, and the difference between the current stock price and the strike price.

There are online calculators you can use to estimate the premium you can expect to receive. Most brokerage platforms provide tools to view potential premiums for various strike prices and expiration dates as well.

If you’re not happy with the premium, you may need to skew the contract terms to favor the seller a bit more. Again, there’s a risk-reward balance at play.

Place the Trade

Once you’ve outlined your contract terms and feel confident in executing the trade, log into your brokerage account and make it happen:

  1. Navigate to the options trading section: Select the stock you own.
  2. Choose ‘Sell to Open’: This action indicates you are selling a call option.
  3. Enter the contract details: Specify the number of contracts (each representing 100 shares), the strike price, and the expiration date.
  4. Review and submit the order: Double-check the details and submit the order.

You can always get brokerage-specific guidance through the customer service of your brokerage if you’re struggling with this step. Trust us – actually executing trades is something you need to feel confident doing so you don’t dig yourself a deep hole on accident.

Monitor Your Position

At this point, the hard work is done. Now it’s just a waiting game. Keep an eye on the stock price and be aware of earnings reports, dividends, or other events that could impact the stock’s price.

Remember, expiration can manifest itself in three different ways:

  • In-the-Money (ITM): If the stock price is above the strike price, the option will likely be exercised, and you will sell your shares.
  • Out-of-the-Money (OTM): If the stock price is below the strike price, the option expires worthless, and you keep the premium.
  • At-the-Money (ATM): If the stock price is at the strike price, the outcome depends on the broker and the specific terms of the option.

You may need to adjust your strategy based on market conditions and your financial goals. Rolling options (buying back the existing option and selling another one with a different strike price or expiration date) can help manage risk and lock in profits.

Streamline Options Trading With VectorVest for Higher Returns

Investing is difficult enough as it is, wouldn’t it be nice if you could implement a stock trading system that transforms complex technical and fundamental data into clear, actionable insights? That’s what VectorVest does, and it’s why it’s considered among the best investment apps for beginners and experts alike.

It has outperformed the S&P 500 index by 10x over the past 20 years and counting while boiling down everything you need to know to make calculated, emotionless decisions into 3 simple ratings. You’re even given a buy, sell, or hold recommendation for any stock at any time – analysis just got a whole lot easier!

Plus, you can streamline your stock picking strategy with our proprietary screeners that bring the best opportunities to your fingertips on a daily basis – whether you’re after aggressive growth stocks, falling stocks to buy, current undervalued stocks, the best stocks for beginners, or anything else for that matter.

By integrating our system with OptionsPro, you can start earning higher premiums with less work and stress. It scans any stock list to uncover those with the highest chance of delivering the best returns. Here are some of its key features:

  • Spot the optimal moment to sell options with theta decay charts.
  • Balance risk/reward seamlessly for any spread trade.
  • Discover undervalued options and avoid overpriced premiums.
  • Pinpoint high-probability trades using unique volatility studies.
  • Identify stocks with the best option premiums instantly using powerful scans.

Whether this is your first time selling covered calls or you just want to raise your chances of success, OptionsPro is a must-have in your toolkit. See what it can do for you today by pairing it with the best stock apps for iPhone or best stock apps for Android!

Bringing Our Beginner’s Guide on Covered Calls Options Strategy to a Close

There you have it – you can now successfully implement your own covered calls options strategy! If you’re wondering how to make money trading options, this is one of the best ways. We hope you feel confident in the process and your ability to put this strategy into action.

We have additional resources to help you learn options trading if you’re interested, including warrants vs options, how to short a stock with options, trading futures vs options, how do options affect stock price, when to exercise options, NQ stock options, building a stock portfolio, the best stock indicators, buying the dip, and more.

But whether you want to sell covered calls or learn how to invest in dividend stocks, the role of a reliable stock advisory cannot be overstated. That’s why you need VectorVest.

Don’t just take our word for it, though. Get started with the best stock research site today and transform your options trading strategy for good!