By: Zachary Scheidt of Street Authority
The covered call strategy is a reliable way to generate income in your investment account on a monthly basis. Basically, this investment approach captures income by selling call option contracts, which speculators purchase in hopes that they will generate outsized returns as stock prices advance. By selling call options, we allow these speculators the chance to make large profits, while we collect high-probability income payments.
Here's how the covered call process works: We purchase shares of stock the same way a traditional investor would. We then sell call option contracts against these shares (one for every 100 shares that we own). Selling these contracts obligates us to sell our stock at the option's strike price, provided the market price is above this level before the option expires.
This approach puts a cap on our potential return because regardless of how high the stock trades, we will still be obligated to sell at the strike price. However, since we are receiving a payment from selling the call contract, known as a premium, this income is very reliable and gives us a much higher probability of a positive return on our investment. So the covered call approach sacrifices the potential for a very high return in exchange for a more stable, reliable income stream.
Choosing Which Call Option Contract to Use
Option contracts are available on a monthly (and in many cases, weekly) basis, giving us more choices in terms of which contracts we want to sell. Traditional call option contracts expire on the Saturday after the third Friday of each month.
When implementing a covered call trade in our account, we must choose an expiration date. Typically, the more time left until expiration, the higher the price will be for the call option. This is because the contract is more attractive to buyers, because a longer time horizon allows the stock more time to trade higher, giving the owner a greater chance to profit. From our perspective as call sellers, a higher price means that we receive more income from selling the contract.
While more income is certainly desirable, we need to always think about how much time is required for the trade to be completed. So while we may set up a covered call trade that pays us an 8% return over the course of the next six months, that return might be less attractive than a 4% return that would be completed in just two months' time.
As a general rule, I typically like to sell call options that expire over the next four to eight weeks. These contracts tend to offer the best per-year rate of return because they expire relatively quickly. Once the contracts expire, we will either be obligated to sell our stock and will then have the capital available to invest in a new covered call setup, or the calls will expire worthless and we will have the option of selling additional contracts to create more income.
While this relatively short-term approach can yield very attractive rates of return, the strategy embraces a bit more risk depending on the strike price of the calls that you sell. This is because the stock could trade significantly lower while waiting for the option to expire. And because shorter-term contracts are sold at a lower price, we don't have as much income from selling this contract to offset the potential losses in the stock.
During turbulent, high-risk market environments, and especially during bear markets, it sometimes makes more sense to sell longer-term option contracts. Remember, the longer the time frame of the option contract, the higher the price for the call options. So by selling longer-term contracts, we are collecting more income in our investment account.
This way, even if the stock trades a good bit lower, we have more income from selling a higher-priced call option to offset the losses in the stock. Of course, selling long-term contracts can have a drawback as well, namely that our capital is tied up in the trade for a longer period. This is especially frustrating if the market begins to move sharply higher, because we have our gains capped by the covered call structure.
But during periods of uncertainty, the additional income and increased stability may be well worth the risk of missing out on the next leg higher. As is usually the case with investing, the protection of capital should be your first and foremost concern, with the appreciation of capital being the secondary objective.
Using longer-term option contracts during high-risk periods gives you a chance to continue to collect reliable income from the covered call strategy, while doing more to protect your initial capital and bypassing much of the volatility that traditional, stock-only investors must endure.
Note: Selling covered calls is just about the easiest way we can think of to generate consistent income in any type of market. In fact, our Options Income Strategist Amber Hestla recently compared it to collecting rent on an investment property. Rather than letting your stocks sit there, you can "rent" them out to other investors.
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