Earn Passive Income by Selling Covered Calls

Synopsis:

Options trading has a reputation for being extremely speculatory, but there are plenty of option trading strategies that are potentially appealing for investors that have a low-risk tolerance.

One of the most popular options trading strategies is selling covered calls, and it could be an excellent way for any long-term investor to gain a little extra income from their stock portfolio.

Selling Covered Calls Explained:

A call option contract gives the buyer the right to buy a stock at a set price (the strike price) on a set date in the future. Investors who buy call options are hoping that the stock’s share price will rise above the contract’s strike price by the expiration date. If it does, the buyer can exercise the contract and buy shares of stock at the contract’s strike, which would theoretically be below the current market price of the stock.

However, there are plenty of occasions in which the underlying stock’s price does not reach the strike price of a call contract by its expiration date. In these cases, the call option expires worthless, or out-of-the-money. The goal of covered call sellers is typically for all the contracts they sell to expire out-of-the-money.

An Example of Covered Call Selling:

The first step in selling covered calls is to own shares of the underlying stock. Many long-term investors have core stock holdings in high-quality stocks such as Apple (NASDAQ: AAPL).

Let’s assume a hypothetical Apple investor holds 100 shares of Apple in their trading account that is worth about $14,600. Assuming they do not believe Apple’s share price will increase more than 50% in the next 6 months, the trader could sell a single call option representing 100 shares of stock expiring in January 2022 with a strike price of $220. That contract recently traded at $0.60, meaning the covered call seller would profit about $60 for selling the contract ($0.60 x 100 shares per contract).

Assuming Apple stock is trading below $220 on January 21, 2022, the contract will expire worthless and the call seller can keep the $60 and the Apple shares.

In a worst-case scenario, Apple stock trades above $220 per share by January 21, 2022. In that case, the call seller’s gains on their 100 Apple shares would be capped at roughly 50% given they would be obligated to sell those shares to the call buyer for $220. Either way, the seller gets to keep the $60.

By selling covered calls you are essentially setting a cap on the potential upside of stock in your portfolio over a given time frame and selling the rights to any gains above that level to the call buyer for a guaranteed sum of cash.

Things to Remember:

The deeper out-of-the-money you go when selling covered calls, the less likely the stock will hit the strike price and force you to sell your shares. However, the deeper out-of-the-money the contracts are, the cheaper they will be priced and the less income you will be able to generate.

If you want to hold onto your underlying stock but the share price hits your strike price before the expiration date, you can simply go ahead and buy more shares of the underlying stock to replace the ones covered by the contract. That way, you won’t miss out on any additional gains the stock experiences before the expiration date.

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