How does selling a covered call work? It took me a long time to confidently answer that question, but today, I hope to provide the same relief and peace of mind to anyone reading this blog post. Option trading involves many moving parts, especially when you’re the seller of the option. When you buy a call or a put option, your main concern is whether the stock will go up or down. If all goes well and the stock you purchased the call on goes up, you can simply click the sell button and collect your profits.
Every buyer of an option has a seller on the other side—an easy concept to grasp, but not something I’ve spent much time pondering in the broader context of option trading. This becomes particularly relevant when you’re actively using an option strategy with assignment risk, such as a covered call strategy.
Why should you consider selling covered calls?
Covered calls give individual investors the ability to increase their market returns by leveraging each 100 shares they hold in their portfolio, far beyond what a traditional buy-and-hold investor would achieve. Personally, I became a fan of this strategy because, when used wisely, it carries a very low risk of significant losses. And if you’re familiar with options, you know that significant losses are often associated with most option traders.
How to get started:
If you’re new to trading and don’t own any stock positions, your first task is to go shopping for some stocks. To enact the covered call strategy, you need to have at least 100 shares of a particular stock. Everyone has a different approach based on their risk tolerance, but let’s say you have $5,000 that you’d like to deploy into the market. My strategy would be to look for 5 stocks that cost $10 or less to add to my portfolio. It’s worth mentioning that the method you use to pick those stocks is crucial—you should have solid fundamental or technical reasons for selecting them.
Due to the nature of selling covered calls, I know that my hypothetical $5,000 portfolio will be a high-risk one filled with speculative stocks. These are companies that are not yet profitable but have significant upside potential. I’d structure my portfolio this way because option selling revolves around collecting premium, which is the money you receive for taking on the risk of potentially losing your shares. The amount of premium you receive is tied to the implied volatility of the option, which is mainly influenced by the risk-reward profile of the stock in question and any significant news events that fuel speculation about the stock’s future price movements.
The riskier the stock, the higher the premium you receive. Take stocks like Palantir or Sofi, for example. Owning these stocks involves perceived risk since they recently went public, but their future prospects look promising, and the market loves to speculate on their growth potential.
How does selling a covered call work?
By now, we’re halfway through this post, but can you answer the question of how does selling a covered call work? In my newly built portfolio of stocks, I now own Sofi. Let’s examine how much we can potentially earn on a weekly or monthly basis from this position. The number of trades you can make in a month will depend on your work and personal life. Let’s assume you can trade once a month; a good rule of thumb is to aim for a return of around 2% to 4%. I’ve found that focusing on those returns has brought me the most success and consistency in my trades.
Sofi is currently trading at $5.39 per share as of May 24th, 2023. So, a 100-share position in the stock would be worth $539. We’re aiming for a roughly 4% return on this stock, which amounts to approximately $20 worth of premium collected in a month. Let’s dive into an example: to open this trade, you would sell a call on Sofi at the $5.50 strike price with an expiration date of June 23rd, 2023. The premium received for this option is $27. By June 23rd, if Sofi is trading at $5.50 or higher, you would be obligated to sell your shares at that price. Additionally, you would receive $0.11 per share for the stock if we assume you purchased it at $5.39. This would result in a total return of $38, equivalent to around a 7% return in one month.
The above example is simplified, mainly focusing on the trade breakdown. Initially, you may experience a few losses, but over time, you’ll gradually determine your win rate. It’s ideal to aim for a win rate of around 85% to 90% of your trades. If you find that you’re losing a significant number of trades, take the time to identify what might be going wrong and adjust your approach accordingly. Commissions play a significant role in your options trades, as the fees you pay per trade directly impact your returns. Research online platforms that offer free or low commissions to find the one that works best for you.
The biggest risks of selling a covered call:
- Risk of missing returns: Consider a scenario where the Sofi stock goes up 10% over the month you sold your covered call. Comparing that increase to your trade, you would have missed out on approximately $53, which is a difference of about 3% from your original trade. This is one of the significant risks of covered calls.
- Stock price decline: Let’s say you bought the shares at $5.39, but the stock price drops to $4.50 per share. This means you would be down approximately 16% on your position. If you made the same trade and were forced to sell the stock at $5.50, which is below your cost basis, you would have incurred an overall loss of about 9% after considering the 7% return you initially made.
- Assignment risk: When selling calls on a stock with a dividend, such as Apple, the counterparty may exercise their right to buy the shares before the expiration date if the stock’s ex-dividend date coincides with the option’s expiration date. They do this to collect the dividend and boost their returns, and that can only happen if they own the shares before the ex-dividend date, leading them to exercise their right to purchase your shares earlier than you intended.
- Opportunity cost: This scenario becomes a concern when you make poor decisions regarding the stocks you choose to purchase when selling covered calls. Always keep in mind that you may need to hold the stock for a long time if there is a significant decline in the stock market. Therefore, ensure that the stock you purchase is one you like, so you can purchase more shares as the price drops.
Now, how does selling a covered call work? There is much more to the strategy of selling covered calls, but I hope this post at least sets you on the right path. Experience will be your best teacher. Trial and error will help you perfect your strategy but remember not to put your entire portfolio at risk on one trade. Over time, you will become more comfortable and confident, and what initially seemed like a large risk will no longer feel that way with your growing experience. Many platforms offer trading simulators for practicing paper trading before you start with real money. This can be a great approach to limit the risk of losing money as you get started.