Covered calls are one of the most common and popular strategies to generating income in mildly up-trending or flat markets. Covered calls, for the uninitiated, are when you own the underlying stock and sell someone the right to buy the stock in case it reaches the strike price before expiration. Experts suggest that the best time to sell covered calls is while establishing a long equity position or when the equity position has already begun to move in the seller’s favor. Keep in mind, that when creating a covered call position, it is best to sell options with a strike price that is equal to or greater than the price you paid for the same equity.
If you sell out-of-the money calls and the stock remains flat, or their value declines or increases, the calls might expire and become worthless. Subsequently you will have the scope to keep the premium that you received when you sold them. Shorting covered calls is a popular trading strategy. While there is an upside, where the traders have limited capped profit, on the downside, they have limited and proportionate loss. Experienced traders would advise that you apply the strategy with the correct timing and selection of expiry and moneyness.
Risks Involved in Covered Call Dealings
While covered calls are an easy way to make money, there are several risks involved in selling them. Below are some of the risks involved in selling covered calls.
Decline in the stock market: While dealing in covered calls, you are set to lose money if the underlying stock undergoes a major price decline. The premium received from selling the covered call will offset only a portion of the loss associated with stock ownership.
Missing out on selling stock at the target price: You might end up losing money if the stock price climbs above the sell option. Consider what would happen to you as a seller if the stock price keepings going up during the contract and then drops when the option expires. The call owner won’t exercise the option and in the end, you are unable to sell the stock.
Stock price surges through strike price: In case the stock price surges through the strike price and advances, you will end up losing the opportunity to sell the stock at a higher price because of the call option. Many people believe that they will end up losing money, but that isn’t true. The seller always ends up making money, but yes, it is lesser than what they would have earned without the option sale.
There are multiple ways to increase your profit from covered calls by reducing the risks involved in the process. Here are some below best practices that will help you reduce the risk from selling covered calls:
Keep in mind the stock price movement: Working with covered calls works if you use stocks that move in a predictable way. It is advised that you use stocks that have medium implied volatility. If the implied volatility is too high or too low, you are in for a loss, but medium volatility will ensure enough premium to make the trade worthwhile. You can calculate the implied volatility by using an options pricing model. This information will you in the long run even though it is hypothetical in nature.
Be prepared for your stock to go down: You need to have a plan in mind for when the stock prices head down. No one likes the situation where the stock prices crash, but as one dealing with covered calls, you have more choices. Unlike what investors believe, you don’t lock yourself in the situation until the expiration of the call. You always have the option to buy back the call and remove the obligation to deliver the stock.
Remove high PE stocks: Investing in high price/earning (PE) stocks are always tempting. They do help you make more money, but as long as their growth and momentum doesn’t stop. These high PE stocks stop selling when the market starts to consider them like the other stocks in the market. This is when you know that the balloon has burst and you will not be able to make any profit from them and their stock prices will come down.
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