Covered calls are a smart way to get more income from your stock portfolio. This options strategy allows you to sell calls on stocks you already own and get more returns. As a relatively conservative options strategy, covered calls give you downside protection and a little bit of upside.
By using covered calls you can get more out of your investments than just stock appreciation. This involves selling calls against shares you own and collecting premium from option buyers. Covered calls may limit your upside on individual stocks but can give you a steady income stream to add to your portfolio.
What are Covered Calls
Covered calls allow you to make money from your stock portfolio. This options strategy involves owning shares of a stock and selling calls against those shares. When you sell a covered call you get paid a premium upfront for agreeing to sell your shares at a set price.
To do a covered call you need to own at least 100 shares of the underlying stock for each call option contract you sell. The call option gives the buyer the right to buy your shares at the strike price before the expiration date. If the stock price is below the strike price the option expires worthless and you get to keep the premium and your shares.
Here are the parts of a covered call:
- Stock ownership: You own the underlying shares
- Call option: You sell a call against your shares
- Premium: You get paid upfront for selling the option
- Strike price: The price you agree to sell your shares at
- Expiration date: The option contract expires
Benefits of covered calls:
- Make extra money from your stock
- A little protection against small price drops
- Boost your overall returns
Risks:
- Limited upside if stock price goes up big
- Obligation to sell your shares at the strike price
- Exposure to downside if stock price drops big
When doing a covered call you need to consider the strike price and expiration date. A higher strike price or shorter expiration period will reduce the chance of your shares being called away but will give you lower premium.
Here’s an example:
You own 100 shares of XYZ stock at $150. You sell a covered call with a $155 strike price expiring in 1 month for $1 per share.
Outcomes:
- Stock price stays below $155: You get to keep the $100 premium and your shares
- Stock price goes above $155: Your shares get called away but you profit from the price increase and premium
- Stock price drops: You get to keep the premium which offsets some of the decline in share value
Keep in mind covered calls work best in:
- Neutral to slightly bullish markets
- Stocks with moderate volatility
- Low interest rates
To use covered calls effectively:
- Choose stocks you can hold long term
- Pick strike prices above your cost basis to avoid losses
- Be prepared to adjust as market conditions change
- Monitor your positions and be ready to act if needed
Covered calls can be a good income strategy but not for everyone or every situation. Consider your goals, risk tolerance and market outlook before you do.
Selling covered calls limits your upside if stock price goes up big. You may miss out on big gains if your shares get called away. But this strategy is good for stocks you think have limited near term growth.
Tax implications are another thing to consider. Premiums from selling covered calls are short term capital gains. If your shares get called away the sale may trigger capital gains tax depending on your holding period and cost basis.
Covered calls can be used in individual brokerage accounts and IRAs. But some retirement accounts may have options trading restrictions so check with your custodian before you do.
To get started with covered calls you’ll need:
- A brokerage account approved for options trading
- Enough shares of stock to cover the call options you want to sell
- An understanding of options basics and risks
- A plan for each position
As you get more comfortable with covered calls you may want to try:
- Rolling covered calls to extend or adjust strike prices
- Using covered calls with other options strategies
- Selling calls on a regular basis
Covered calls can be a good tool for income and risk management but they require ongoing work. Be prepared to put in time to monitor your positions and adjust as needed.