Options for Income: Selling Covered Calls (Part I)

Options for Income: Selling Covered Calls" provides a concise overview of how investors can generate additional income from their stock portfolios by selling call options against stocks they already own. This strategy highlights the balance between earning premium income and managing the potential obligation to sell the stock at a predetermined price, offering a practical approach for investors looking to enhance their investment returns while maintaining a degree of control over their assets.

STOCK INVESTING

2/25/20243 min read

Welcome to our Advanced Dividend Investment Strategies Series

Imagine if there was a way to squeeze additional income out of the stocks you already own, without having to sell them. Welcome to the world of selling covered calls, a strategy that can enhance your investment returns, provide a measure of protection in a flat market and offer a strategic approach to generating income. This isn’t just about investing smarter—it's about unlocking the potential of your portfolio in a way you may not have realized was possible.

Introduction to Options

Before we dive into the specifics of selling covered calls, let's briefly touch on what options are. Options are financial derivatives that give buyers the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset at a predetermined price, on or before a specific date. While options can be used in various complex strategies, one of the simplest and most effective ways to utilize them is by selling covered calls on stocks you already own.

What is a Covered Call?

A covered call involves selling a call option on a stock you already hold in your portfolio. This strategy allows you to earn an income, known as the option premium, which the buyer of the call option pays you. In exchange for this premium, you agree to sell your shares at the option's strike price, if the option is exercised by the buyer. This strategy is best employed in a flat or slightly bullish market, where the stock price is not expected to rise significantly above the strike price before the option expires.

Benefits of Selling Covered Calls

  1. Additional Income: The primary benefit is the generation of income from the option premium, which can help boost overall returns, especially in sideways markets.

  2. Downside Protection: The premium received can offset some of the losses if the stock price declines, providing a cushion against market downturns.

  3. Portfolio Management: Selling covered calls can be a proactive way to manage your portfolio, potentially exiting stocks at a predetermined price if the options are exercised.

Detailed Example

Let's say you own 100 shares of XYZ Corporation, currently trading at $50 per share. You decide to sell a covered call option with a strike price of $55, expiring in one month, for a premium of $2 per share.

  • Scenario 1: XYZ Corporation's stock price remains under $55 by expiration. The option expires worthless, and you keep the $200 premium (100 shares x $2 premium) plus your 100 shares. Your income is the premium, which can offset any slight decreases in the stock price or enhance your returns.

  • Scenario 2: XYZ Corporation's stock price rises above $55, and the option is exercised. You sell your 100 shares at $55, the strike price. Your profit from the shares is $5 per share (the difference between the strike price and your original purchase price, assuming it was lower), plus the $200 premium. While you benefit from the stock's appreciation and the premium, you might miss out on additional gains if the stock's price soars well above $55.

Risks and Considerations

  • Cap on Upside Potential: The major drawback is that you may have to sell your shares at the strike price, potentially missing out on significant gains if the stock price rockets past this level.

  • Market Risk: If the stock price falls significantly, the premium received won't fully offset the capital losses, although it provides some cushion.

Conclusion

Selling covered calls is a nuanced strategy that offers investors a way to generate income and potentially improve the returns of a well-curated investment portfolio. It's particularly appealing for those looking to earn passive income from their investments or seeking a measure of downside protection in uncertain markets. However, it's essential to approach this strategy with a clear understanding of your investment goals and risk tolerance, as well as a thorough knowledge of the underlying stocks in your portfolio. By employing covered calls judiciously, investors can enhance their income and manage their portfolios more proactively, turning the stocks they own into a source of regular income.

Read Part II and Part III and Part IV Part V

Lastly, if you've decided that you would like to move forward and get started we have you covered. We recommend Webull to get started. We would start small and add more as you get comfortable. Get started by going to their signup page here.