Introduction to Selling Covered Calls

Investing in covered calls can be a strategic move, especially for investors who are looking for additional income from their existing stock holdings. This article explores the benefits and disadvantages of selling covered calls, and offers recommended strategies to consider.

Understanding Covered Calls

A covered call is a trading strategy in which an investor sells (or “writes”) a call option on a stock they already own. By doing so, the investor receives a premium, which is essentially extra income earned from the potential price appreciation of the underlying stock. However, this premium is the only income received, and there is no additional risk incurred compared to owning the stock without the call option.

Benefits of Selling Covered Calls

The primary benefit of this strategy lies in the additional income generated from the premium received. Moreover, since the option premium received provides a cushion against short-term losses, the overall risk is not increased by selling covered calls. In fact, it can be argued that the strategy reduces overall risk as the premium acts as a buffer in case of a slight market downturn.

LEAPs and ATM Strategies

For buy-and-hold investors, selling Long-Term Equity AnticiPation Securities (LEAPs) can be an effective approach. LEAPs have a longer expiration period, often one year or more, and are “at the money” (ATM), meaning the strike price is close to the current market price. This strategy guarantees a certain level of income, even if the stock price moves sideways, and provides a safety net if the stock price declines.

Aggressive Strategies in Selling Covered Calls

While LEAPs and ATM strategies are low-risk, there are also more aggressive strategies that can increase the potential income available from selling covered calls. One such strategy is selling puts, which is akin to buying a call on the same stock. This approach involves collecting a premium and owning the stock if the stock price falls below the strike price, providing the investor with upside potential.

Rolling Covered Calls and Time Value

Another strategy is to consistently “roll out” the option by selling a call with a later expiration date as the existing call dries up. This process is called rolling, and it can be used to maximize the income from the premium. When the stock price rises, the investor can roll up to a higher strike price, increasing the potential for premium income.

Challenges and Risks

While the strategy of selling covered calls can be lucrative, it also comes with certain risks. Aggressive strategies like selling weekly calls or using put options can provide higher income but also expose the investor to greater risk. For instance, if the stock price drops, the loss from the option premium can exceed the income collected, potentially leading to a net loss.

Another risk is that of the market dropping significantly, which can erase the previously earned income. Additionally, investors need to be prepared to sell their shares if the stock is called away, which may not always be a favorable outcome.

Expert Advice on Selling Covered Calls

Options expert Larry MacMillan suggests a nuanced approach to selling covered calls. He recommends selling puts in lieu of covered calls, and if the put is exercised, advises against holding to expiration. Instead, he advises selling covered calls on the shares received from the put exercise as a way to mitigate risk.

Conclusion and Recommendations

In conclusion, selling covered calls can be a beneficial strategy for generating additional income and reducing risk. It is important to carefully consider the risks involved, especially with more aggressive strategies, and to tailor the strategy to one’s investment goals and risk tolerance. Whether you are a buy-and-holder or looking for more income, understanding the benefits and disadvantages of covered calls is key to making informed investment decisions.

For further insights and detailed strategies, it is advisable to explore books and resources dedicated to covered calls and other option strategies.