Many investors prefer dividend stocks for the steady income stream they offer. Another way to generate income from a stock that you own is to sell covered calls on it. A covered call is an option call contract sold by the owner of a stock. The call generates a premium for the seller. When to sell covered calls is when one believes that a stock will not go up sufficiently in price for the buyer of the call contract to exercise it and compel the covered call seller to sell the stock. When this strategy is properly used it can provide a steady income stream alongside dividends.
How Does Selling Covered Calls Work?
Investors use covered calls as a source of income similar to collecting dividends on stocks that they own. This strategy provides a steady stream of extra cash when the owner of the stock is able to accurately predict that the stock will not rise in price during the term of the call option contract. The call contract is “covered” because if the stock does go up in price and the buyer exercises their option to buy the stock in question, the owner of the stock need only hand over stock that they already own which means they do not need to pay out of pocket at a higher market price than the strike price at which they will be paid. This strategy works best for stocks that tend to trade in a channel and the seller only uses this approach when fundamentals, market sentiment, and technical indicators tell them that the stock is likely not to rise in the near future.
Investors like to use this approach because they make a little extra income from a stock that probably has gone through its growth phase and now is a large cap company that is a secure investment but not likely to multiply in value like it did in prior years. However, even big cap stocks do grow with the economy and they may grow significantly in a bull market. The worst case scenario with a covered call is that the stock goes into a bull market rally and the buyer exercises their option to buy the stock. The seller gets paid for their stock at that point. They miss out on the bull market rally. And they may have to pay substantial capital gains taxes on a stock that they owned for many years and had appreciated significantly in value over that time. If they had expected to keep such a stock into their retirement years and then sell a few shares from time to time when their income was lower this opportunity goes away when the stock is called away. Perhaps the only time one does not worry about having to sell the stock is when the owner was going to sell anyway, in which case they get paid for the stock and collect a premium on the call contract as well.
Choosing the Right Strike Price When Writing Covered Call Options
When using the covered call strategy, one needs to choose a strike price that is sufficiently close to the market price that the premium paid is worth the effort of using this strategy. One needs to pick a strike price that provides a little breathing room for the stock in question so that it is not called away due to normal market fluctuations. And the owner of the stock should choose an expiration date that fits their projection as to their stock either trading sideways or even falling a bit in price. When choosing the strike price and expiration date anyone who is using this approach needs to assess their comfort level with possibly having to sell the stock, pay taxes, decide what to do with the cash that they receive, etc. If you are really not comfortable with the idea of using the stock, you need to accept a lower income yield from this strategy which means a significantly higher strike price and a nearer term for contract expiration.
When to Sell Covered Call Options – SlideShare Version