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Covered calls, explained
A covered call is an options trading strategy that involves selling (also known as “writing”) call options on a stock you already own. As a seller, you'll receive a premium in exchange for giving the buyer the right to purchase the stock from you within a specified time frame for a certain "strike price."
Selling covered calls is a relatively conservative strategy in the world of options trading because you won't incur any extra cost if the option holders exercises their right to buy the shares — though you could be forced to sell at a price that's below market value.
Covered calls may be enticing for investors who want to make a modest bet that prices will soften or decline in a bear market. If you believe the price of a stock you own might not meet current expectations on the market, you can sell a covered call in hopes that you'll collect the premium and keep the stock, too.
For example, suppose that you own Amazon shares and want to collect passive income from them. Amazon doesn’t pay dividends, but if you sell call options on your shares, and those options go unexercised, you’ll receive a “dividend-like” payment from the sale of the options without having to do anything in return.
» Need to back up a bit? Check out our primer on call vs. put options.
Are covered calls good or bad?
Selling a covered call is generally seen as a conservative strategy favored by investors who are looking to collect more income from their portfolios. But like any investment strategy, covered calls have their particular risks and tradeoffs.
Pros of covered calls
Managing risk: Selling a covered call can limit the downside risk you take on when you sell an option. In contrast to a "naked call," in which you may have to buy a stock in order to sell it at the option price, covered calls involve stocks you already own and have presumably paid for.
Income potential: When you write a covered call, you get a premium in return. If the buyer never exercises the option because the strike price isn't attractive, you get to keep that premium — and you don't have to sell your stock.
Bear market strategy: You might consider a covered call as a way to make some money and hang onto your stock through what you believe could be a rough patch.
» Learn more: Should I buy stocks now?
Cons of covered calls
FOMO: Covered calls can also cause you to miss out on money you could make by simply holding your stock through a period of growth. If your stock's market value exceeds the strike price, the option buyer will be able to buy it and pocket the profit.
Limited upside: A naked call, while riskier, can carry higher rewards because you don't need to have an initial investment in the stock on which you're selling the option.
» Learn more: Investing during a recession
Covered vs. naked call selling
You don’t necessarily need to own a stock to sell calls on that stock. Doing so without owning the underlying stock is called naked call selling, and is a very risky way of betting against that stock.
For the most part, brokerages only allow experienced investors with margin accounts to sell naked calls because the naked call seller must be able to immediately purchase the underlying stock at the market price and deliver it to the buyer if the trade goes against them.
Selling a covered call, on the other hand, means selling a call on a stock you do own. Selling a covered call doesn’t necessarily mean betting against the underlying stock; it can also be a way of generating additional income from your stock holdings.
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How does a covered call strategy work?
A covered call strategy typically involves selling out-of-the-money calls (i.e., calls where the strike price is above the market price) on a stock you own.
If the market price stays below the strike price, then you keep the premium — and the stock. The option expires unexercised, and you walk away with free money just for owning the stock.
If the market price goes above the strike price and the buyer exercises the call, then you still keep the premium, but you have to sell the stock to the buyer at the strike price. This sale would typically still be profitable for you — the strike price would generally be more than you paid for the stock — but it would be less profitable than selling at the higher market price.
So, the upside of a covered call strategy is the chance of collecting a premium just for owning a stock. The downside is the chance of missing out on profits above the strike price.
Covered call ETFs
Investors who are interested in covered call strategies but don’t want all the hassle of options trading may want to consider covered call exchange-traded funds.
Covered call ETFs typically invest in a stock index — such as the Nasdaq 100 or the S&P 500 — and then sell calls against that index in an effort to generate additional income.
However, they don’t always accomplish that goal. At the time of publication, some S&P 500 covered call ETFs had lower yields than ordinary S&P 500 ETFs.
Covered call ETFs also typically have higher expense ratios than non-covered-call ETFs tracking the same index.
» Another strategy: Invvesting in index funds