Covered calls are a strategic options trading method often used by investors to generate additional income from their stock holdings. This approach is especially beneficial in periods of low volatility, where stock prices remain relatively stable. The main goal behind writing covered calls is to enhance the returns on your existing investments, leveraging your current stock portfolio to boost income.

This strategy can provide value not just for advanced investors but also for beginners, especially those involved in trading or looking for ways to make passive income through an ETF or individual stocks. Here, we will walk through the essentials of covered calls, exploring their benefits, and outlining a simple, step-by-step approach for getting started.

Materials or Tools Needed

To begin generating income with covered calls, you will need a few prerequisites and tools:

• Stocks or ETFs: At least 100 shares of an underlying stock or ETF, which you’ll use to write calls.
• Options Trading Account: You’ll need access to an options trading platform. Ensure that your broker allows options trading.
• Market Research Tools: Access to market analysis tools, such as price charts, volatility indicators, and trading news.

Step-by-Step Instructions

Step 1: Understand the Basics of a Covered Call Strategy

Before executing a covered call, it’s essential to understand its components. A covered call involves holding a stock (or ETF) and selling a call option against that position. The stock acts as “coverage” for the call, meaning you are obliged to sell it if the buyer of the call exercises the option. You earn a premium for selling the call option. If the stock price doesn’t exceed the strike price, you keep both the premium and the shares, enhancing your income.

This strategy works well when you expect the stock price to remain relatively stable.

Step 2: Choose the Right Stock or ETF

Selecting the correct stock or ETF is key to maximizing your income. Ideally, you want to pick a stock that you believe will trade sideways or slightly up during the option’s duration. Stocks with high volatility can be risky since a significant price jump might force you to sell your stock at the strike price, potentially losing out on future profits. For beginners, ETFs are often a safer choice due to their built-in diversification.

Ensure you have at least 100 shares of your chosen asset since this is the minimum required to sell a single call option.

Step 3: Pick an Expiration Date and Strike Price

When selling a covered call, you need to decide on the option’s expiration date and the strike price. The expiration date is when the option contract ends, and the strike price is the price at which you’re willing to sell your shares. Typically, investors select a strike price above the current stock price, allowing for potential capital gains while still collecting the premium.

Short-term expiration dates (30-45 days) are popular among traders, as they allow for quick adjustments and frequent premium collections.

Step 4: Execute the Covered Call

Once you’ve selected the expiration date and strike price, it’s time to execute the trade. Through your brokerage account, navigate to the options trading section. Choose the “Sell to Open” option on the call option and enter the number of contracts you’d like to sell (each contract corresponds to 100 shares).

After executing, you’ll immediately receive the premium from the sale of the option. This premium is your income regardless of how the stock performs before expiration.

Step 5: Monitor and Manage the Position

After selling the call, it’s important to monitor your position regularly. Pay attention to the stock price and the option’s price. If the stock rises above the strike price, you may be forced to sell your shares. However, if the stock price remains below the strike price, the option will expire worthless, and you will keep both your shares and the premium.

You can repeat this process for consistent income or adjust your strategy if the stock price moves unexpectedly.

Do’s and Don’ts

Do’s:

• Do use covered calls for income generation: This strategy is an effective way to boost returns, especially in sideways markets where there is little price movement.
• Do use it with stable stocks or ETFs: The best results come from assets you expect to trade within a narrow range during the option’s lifespan.
• Do reinvest the premium: You can increase your returns by reinvesting the premium you collect from selling call options.

Don’ts:

• Don’t use covered calls on highly volatile stocks: While premiums are higher for volatile stocks, the risk of the stock price exceeding your strike price is also greater, which could result in losing shares at a lower value.
• Don’t sell covered calls without a plan: Set clear goals regarding the price movement you anticipate and how you’ll respond if the stock price rises significantly.
• Don’t neglect your portfolio’s diversification: Covered calls are a great income-generating strategy, but they shouldn’t be the only tool in your investing arsenal.

Conclusion

Covered calls are a powerful income-generating strategy that allows investors to profit from the stock market without having to sell their shares immediately. By carefully selecting the right stocks or ETFs, choosing appropriate strike prices and expiration dates, and monitoring positions regularly, you can consistently generate returns. Whether you are a beginner or a seasoned trader, covered calls can be an excellent addition to your investment strategy.

FAQs

Resources

• Bankrate. Covered Call Options Strategy.
• Corporate Finance Institute. Covered Call.
• Fidelity. Covered Call.
• Investopedia. Covered Call.
• Schwab. Options Trading Basics: Covered Call Strategy.