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The last two years have seen record options-trading volumes, thanks to historic volatility and the rise of mobile brokerages.
If you’re new to options trading — or you’re thinking about getting into it — you might be wondering which strategies are right for you. One simple type of options trade is the covered call.
What is a covered call?
A covered call is an options trading strategy that involves selling (also known as “writing”) call options on a stock you own, in an effort to collect the option premium.
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.
Like any other investment strategy, selling a covered call has risks, but it’s generally seen as a conservative strategy favored by investors who are looking to collect more income from their portfolios.
To explain what covered calls are in simpler terms, we’ll go over some basic options terminology.
Options are tradeable contracts whose value is based on the price of an underlying stock. They come in two varieties: puts and calls.
When you buy a call, you make a small payment (the “premium”) in exchange for the right to purchase the underlying stock at a set price (the “strike price”) on or before a specified date (the “expiration”).
Buying a put is similar, except that it gives you the right to sell the underlying stock at the strike price on or before expiration.
Calls are profitable for buyers (or “in-the-money”) when the market price of the underlying stock is above the strike price because exercising the option (buying the stock at the strike price) would mean buying the stock for less than it’s worth.
Puts are profitable for buyers when the underlying stock is trading below the strike price because exercising the option would mean selling the stock for more than it’s worth.
But puts and calls don’t just have buyers — they also have sellers.
When you sell a call, you collect the premium from the buyer, and in exchange, you’re obligated to sell the underlying stock to the buyer for the strike price, if they choose to exercise the option before expiration.
Call sellers are hoping that doesn’t happen. If the option is in-the-money and the buyer exercises it, then the seller has to give them the underlying stock for less than it’s worth. If it’s out-of-the-money and the buyer doesn’t exercise it, then the seller gets to keep the premium without doing anything.
The four options market participants and their incentives
Bullish. Hopes that the underlying stock will trade above strike price by expiration so that the option can be exercised or resold.
Bearish. Hopes that the underlying stock will trade below strike price by expiration so that the option can be exercised or resold.
Bearish. Hopes that the underlying stock will trade below strike price at expiration so that the option expires worthless and they can keep the premium.
Bullish. Hopes that the underlying stock will trade above strike price at expiration so that the option expires worthless and they can keep the premium.
» Need to back up a bit? Check out our primer on how to trade options
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.
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.
The bottom line on selling covered calls
In theory, selling covered calls can boost your returns on your stock holdings by generating income from stocks that aren’t rising very fast. But it’s not without risk and may not be a good replacement for conventional buy-and-hold investment strategies.
A 2022 study by the London Business School examined a set of U.S. retail options trades between 2019 and 2021, tracking their average returns across a variety of time horizons. It found that the average retail options trader lost money across every time period studied.
So while it’s possible to make money with options-trading strategies like covered calls, the numbers suggest that most investors don’t.
For comparison, the S&P 500 index has returned an average of about 10% per year for most of the last century. In some years, the index performed better than that, and in other years, it performed worse.
But all of the investors who hold an S&P 500 index fund or ETF over a given time period will earn the same return. And the longer they hold it, the closer their returns will be to that steady 10% annual average.
» Learn more about investing in index funds