Covered calls are a great way to generate higher returns on your stock investments. This type of investment strategy involves selling call options against stocks that you already own. When done correctly, this can provide you with additional income and downside protection on your stock holdings.
In this blog post, we will discuss the basics of this investment strategy and how they can be used to improve your investment portfolio!
How Covered Calls Work
Covered calls are a type of options strategy that can help generate income and provide limited downside protection. When you write a covered call, you sell (or “write”) call options on a stock that you own. By doing so, you collect a premium from the option buyer.
If the stock price goes up, the option will be exercised. When this occurs then you will sell your shares at the strike price plus the premium collected. If the stock price doesn’t move or falls, you get to keep both your shares and the premium collected.
There are two key things to remember when writing covered calls:
- Covered calls only work if you own 100 shares of stock for each call contract written.
- Covered calls have an expiration date. This means you need to make sure the stock is above the strike price at that time.
Covered call writing also has the advantage of providing some upside protection in case of a sharp decline in stock prices. For example, if you own shares of XYZ company at $50 per share and write one covered call contract with a strike price of $55, your maximum loss is limited to $50 per share (the price you paid minus the premium collected).
On the other hand, if the stock price falls below the strike price, you may be “assigned” and have to sell your shares at the strike price. This is true even if it’s below the current market price. This is because the option holder has the right to “call away” your shares at the strike price.
To summarize, when you write a covered call, you’re giving the option holder the right to buy your shares at a set price (the strike price). In exchange, you collect a premium from the option sale. You are making money from selling the option and you’re also protected in case of a sharp decline. You are protected because you have already sold the option and will not have to sell your shares at a lower price.
How Covered Calls Generate Passive Income
One of the key benefits of writing covered calls is that it can help generate passive income. Covered call writing is a way to collect regular payments as long as the stock price doesn’t fall too far.
For example, let’s say you own 100 shares of XYZ stock. Each share is currently worth $50. You could write one covered call contract for every 100 shares of stock you own.
Assuming each contract is for 100 shares, you would receive a premium of $500 per contract. If the stock price stays above $50 per share until expiration, the option will expire worthless and you keep the entire premium as profit.
If the stock price falls below $50 per share, the buyer of your call option can exercise their right to purchase your shares at $50 each, even though the current market value may be lower.
You would still make a profit on the trade because you collected more in premiums than you paid out to buy back the shares. Covered call writing is a great way to generate income from stocks that you would otherwise just hold on to.
Covered Calls Strategy: Common Mistakes To Avoid
Now that we’ve covered the basics of how covered calls can generate passive income, let’s take a look at some common mistakes investors make when employing this strategy.
One mistake is not monitoring the stock price and the option premium changes. Covered call writing is a dynamic process and you need to be aware of how both the stock price and options premiums are moving.
Another mistake is not rolling over your options when they get close to expiration. Covered call writers need to constantly monitor their positions. They may also need to roll over their options to new contracts with later expiration dates when necessary.
Lastly, many investors don’t realize that they can write covered calls on stocks that they don’t own. This is called “writing naked calls” and it’s a high-risk strategy that is not suitable for most investors.
Covered calls are a great way to generate passive income from stocks. By understanding how they work and avoiding common mistakes, you can use this strategy to your advantage.
The Risks of Covered Calls
Covered calls are not without their risks. The biggest risk is that the stock price will increase and the option will be exercised. This forces you to sell your shares at the strike price. If the stock price increases enough, you could miss out on substantial profits.
Another risk is that the stock price may fall and you could be forced to buy it back at a higher price than what you sold it for originally. Covered calls also have time decay working against them, as the value of the option decreases as expiration nears.
Finally, if there is a large move in either direction, your gains may be limited by the strike price of the option.
Despite these risks, covered calls can still be an effective way to generate income and enhance returns in a portfolio. When used properly, they can help you manage risk while still allowing you to participate in upside potential. Just be sure to understand the risks involved before you enter into any covered call trades.
Best Types of Stocks For Covered Call Strategy
The covered call is a very popular options strategy. It enables the investor to generate income from their stock portfolio while at the same time reducing downside risk.
There are certain types of stocks that are better suited for this strategy than others. In general, you want to look for stocks that are:
- Solid blue-chip companies with a history of consistent dividend payments
- Large-cap stocks that are less volatile and have lower betas
- Stocks trading near 52-week lows or support levels
- Stocks with high levels of liquidity
If you can find stocks that fit all or most of these criteria, then you will be well on your way to success with the covered call strategy. Remember, the key is to find stocks that are less likely to experience large price movements so that your downside is limited.
Types of Stocks To Avoid Writing Covered Calls On
There are also certain types of stocks that you will want to avoid when employing the covered call strategy. These include:
- Stocks with high levels of volatility
- Small-cap stocks
- Penny stocks
In general, you want to steer clear of stocks that are more likely to experience large price swings. The last thing you want is for the stock price to make a big move and have your option get exercised only to see the stock price drop back down again.
You also want to avoid stocks that don’t have a lot of liquidity. This is because you may not be able to exit your position if the stock price starts to move against you and there are no buyers in the market.
Finally, you want to stay away from penny stocks as they tend to be more volatile and more prone to fraud.
Covered calls are a great way to generate income from stocks, but it’s important to understand the risks involved before entering into any trade. Be sure to select the right stocks and avoid those that are more likely to experience large price movements. With a little bit of planning and foresight, you can use covered calls to your advantage.
This strategy requires a little more financial IQ, however, if you are looking for a slow and steady way to make extra money, this is the perfect method for you.
Investing in Covered Calls – Summary
It’s important to remember that the covered call strategy will not make you rich overnight. It is a slow and steady way to generate additional income from your stock portfolio. But if you are patient and disciplined, it can be a very effective way to increase your returns over the long term. By following these guidelines, you can help ensure that your covered call trades are successful.