What is a covered call?

A covered call is the most popular way of generating an income through options. There are two steps required for an investor to execute this strategy – owning a minimum of 100 shares of a stock and shorting (selling) an “out of the money” call option. This income strategy is effective when there is a neutral or bearish sentiment on a stock. As the investor is the seller of the option contract, he/she receives an immediate income in the form of the premium paid by the buyer of the contract. 

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Deciding on a suitable strike price

An investor selling a covered call would look for an out of the money (OTM) strike price. In the case of selling a call, an OTM strike price would be higher than the current market price of the stock. For example, if AAPL was trading at 170, an investor would want to sell a call option with a strike price at 185. The more OTM the call option is, the less premium would be paid to the seller as there is a lower probability of the stock price reaching the strike price within the life of the contract. Picking a strike price that is close to the current market price of the stock may be tempting as there is a higher premium received, but there is also a higher probability of the stock reaching the strike price during the life of the contract. 

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Why use a covered call instead of a sell limit order?

Using the example above, selling a Jan 2019 $185 call @ $3 generates an immediate income of $3 per share (so $300 in total). Assuming the investor bought the shares at $170, the covered call strategy would be profitable if the market price of the stock remained above 167 (170 – 3 premium), whereas the sell limit strategy would only be profitable if the stock remains above 170. Another key advantage the covered call strategy has in this case is the length of exposure. An investor using the covered call strategy only has exposure until the expiration date while the sell limit strategy exposes the investor until AAPL reaches $185.

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Best Practices

Selling short term options (3-7 weeks) tend to provide better results. Short term option contracts have an advantage over long term contracts due to earnings cycles. Longer term options are exposed to more earnings releases that causes them to be subject to large price movements.

As mentioned earlier, an investor using a covered call strategy would find it beneficial to use an OTM strike price as there is a lower probability of the stock to reach that price. However, OTM strike prices and premium received have an inverse relationship. The selection of a suitable strike price can be optimized by using Delta. Delta represents an approximation of the probability that the stock price will stay below the strike price. This is explained further in “Generating Consistent Income with Covered Calls”.

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Summary

When it comes to using a covered call strategy, the goal is to hold the contract until the expiration date. Therefore, it is important to pick a strike price and expiration that minimizes the risk of the stock reaching that price while maximizing the premium received. In other words, an investor would want the option to expire worthless. Once the option expires worthless, the covered call strategy can be repeated, and this generates a consistent stream of income from simply owning the stock.