Covered Call Options Trading Explained

When you run through the gamut of options trading strategies, one stands out as a go-to for conservative-minded investors, the covered call.

The reason it’s so popular is that, in some respects, it’s akin to a dividend investing except the investor selects the yield. And rather than getting paid once every quarter, it’s possible to proactively generate income as often as weekly. 

So how does it work?

Covered Call Options Trading Explained

A covered call allows the owner of a stock to get paid for agreeing to sell their shares at a specific price.

Imagine owning 100 shares of Palantir stock at $17 per share. Now further consider that if you could sell Palantir at $20 per share, you would be delighted. After all, it’s trading in the market at a price $3 per share lower than your commitment.

How much would you pay in order to sell your stock at a higher price than where it’s trading in the market? Well, it turns out you don’t have to pay a dime. Instead, you get paid for agreeing to sell your stock at a higher price.

That might seem too good to be true if it’s your first time coming across the strategy, so we’ll get to the catch in a moment.

First, let’s highlight yet another positive aspect of the strategy by assuming that you get paid $1 per share for making the deal.

Now, instead of your cost basis and risk in the trade being $17 per share or $1,700 for every 100 shares you own, it’s just $16 per share or $1,600 total after receiving $100 for selling 1 call contract (because 1 options contract corresponds to 100 shares of stock).

If the covered call seems like the best trading strategy you have come across it might just be because you can repeat the strategy regularly. Unlike a dividend income strategy that relies on payments on the schedule set by the Board of Directors, a covered call strategy is applied on the schedule selected by the investor.

Still, there are a couple of things to be aware of when trading covered calls.

Covered Call Risks Explained

If you have got this far and thought the covered call strategy is the holy grail because you agree to sell your stock at prices higher than where they are trading while lowering overall risk, a voice has probably started to grow louder in your head wondering what’s the catch?

The answer is quite simple. When the stock rises beyond the price at which you agreed to sell, you are obligated to sell it.

Returning back to the Palantir example, consider the share price rising all the way to $25 per share after you agreed to sell the stock for $20 per share, the obligation of the trade means you don’t have a choice but to sell it at $20 even though the market price is $5 higher.

As you can see, the tables quickly turn inside a trader’s mind from thinking “how great it would be to sell a stock trading at $17 per share at $20 per share” to “what have I done agreeing to sell the stock at $20 now that the share price is $25 per share.”

It’s this tug of war between greed and fear that defines trading in so many ways and it surfaces in covered call trading too.

So how do you conquer this common pitfall?

How Do You Control Fear and Greed?

The best way to get past the emotional swings is to think rationally about what return on investment is reasonable over a particular time frame.

To translate that into an example, consider the $17 stock again and imagine what percentage return you would be happy with over what window of time. The odds are if you could generate a $3 gain over the course of 3 months you would be quite happy because it would translate to a 17.6% gain in a quarter, or an astronomical 70.5% in a year.

Few traders would shy away from such a high and guaranteed return with the exception perhaps of some champion traders who have demonstrated even better track records. For most ordinary traders, though, such a return would be stellar and more than acceptable.

So now, when a trade is first initiated it’s best to set a goal for a percentage return and commit to it. For easy math, we’ll stick to the $3 gain on the $17 stock and consider that would be an excellent return over the course of a quarter.

Now if the stock goes to $25 per share, we simply accept that we maximized the return possible and stem the tide of regretful emotions that start to bubble up after the fact.

As it turns out, however, the return is even better than the $3 per share described above because, in addition to it, is a $1 return from the sale of the call option.

In reality the return on risk is $4 per share on $16 of risk or 25% if the share price rises to $20 or above.

A further way to think about the covered call is that you would be no worse off selling the call option for $1 than holding the stock from $17 to $21.

In both examples, a profit of $4 is generated. The difference between simply holding the stock and making the $4 per share versus entering the covered call strategy is that the risk is also reduced by $1 from $17 to $16 per share by selling the call option.

Is It Worth Selling Covered Calls?

A cursory glance at the covered call strategy might lead the average investor to assess that it’s a pretty intriguing strategy but perhaps not worth pursuing. 

After all, it seems that you could make say $3 on the stock and $1 on the option in the example above but the downside is you would miss out on the share price gains all the way to $25 per share.

This viewpoint is correct but it risks missing the larger picture. The first point to note is that it’s no mean feat picking the right time to sell a stock. So as nice as it is to imagine selling the stock at the peak of $25 per share, the reality is most traders don’t time their exits very well, and that means risking giving up those gains.

However, that’s not the most compelling argument to trade covered calls. If you’re wondering is it worth selling covered calls just consider the gains that are possible over time. Certainly, selling a call for $1 per share over the next 3 months is a modest return but now imagine doing so each and every quarter. 

By repeating the strategy for 17 quarters in a row, a trader can with each passing quarter effectively reduce the cost basis of their holding by $1 resulting in essentially a $0 cost basis after just over 4 years.

Yet there is no limit on how often they can keep selling calls. As long as the stock keeps trading and the options can be sold, the trader can sell the calls ad infinitum year after year, decade after decade. 

And if some quarters the stock is sold because the share price rises above the agreed upon threshold, so be it. It can be bought back and calls sold once again.

That is the benefit of the covered call strategy – the control of when to sell the calls and which calls to sell are in the hands of the trader. This contrasts sharply with a dividend yield which is entirely at the discretion of the company’s Board of Directors.

As such, the covered call strategy is an excellent way to proactively generate income at a schedule chosen by the trader and more aligned with their own preferences for reward and risk.

Lastly, if a stock falls instead of rises right after the trade is entered, the cost basis is lower than simply holding stock alone so it means that entering covered calls in down markets leads to better returns than sticking with equity holdings alone.

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.