A covered call, also known as a buy-write transaction, is a popular options strategy that generates income and reduces some risk of holding a stock. The trade-off? You must be willing to sell your shares at a predetermined price, known as the strike price.
How to execute a covered call:
Buy the underlying stock as you normally would.
Simultaneously, write (sell) a call option on those same shares.
Benefits of covered calls:
Selling calls can provide a steady income stream. Conservative option writers who own the underlying stock can potentially earn an extra 1–2% return every three months. While option selling generates positive cash flow, it is incorrect to conclude that covered calls generate investment income. The call option seller receives immediate cash flow but also incurs a future liability. This liability obligates the seller to sell the underlying stock at a predetermined price if the option buyer exercises the option, potentially resulting in the stock being sold below market value.
By selling a call, you hedge against price fluctuations. If the stock price rises, the loss from the call is offset by gains in the stock. If the stock price falls, the premium received from selling the call cushions the loss.
Suppose you own 100 shares of a stock. For every 100 shares, you sell one call option. This is a covered call because your short call is backed by your long stock position. If the stock price increases, the premium received from the call allows you to effectively sell your stock at a higher level than the strike price (strike price + premium). Potential loss if the stock price drops significantly.
When to use covered calls:
Ideal when you have a short-term position in the stock and a neutral opinion on its direction.
Useful for generating income through the sale of the call premium.
Provides some protection against a potential decline in the stock’s value.
Covered calls can also be a strategic tool for portfolio rebalancing, serving as an alternative to directly selling stocks.
Choose a strike price slightly above the current stock price to maximize premium while retaining potential for capital gains. Typically, 5–10% above the current price is a good range. Use tools like the Black-Scholes model to estimate fair option prices. For example, if a stock trades at $100, consider a strike price of $105–$110 with an expiration of 1–2 months, depending on volatility and your return target. Analyze the stock’s historical volatility to estimate potential price movements.
However, covered call strategies have significant drawbacks that investors often overlook or misunderstand.98 Let’s examine the goal of achieving a derivative yield of 6% annually by selling call options on an index.
Each month, you select a strike price for selling a call option with a target price of 0.50% of the SPX index value. From 1999 to 2023, the value of these options at expiration was 0.54% of the SPX index value, while the average selling price was 0.49% of the SPX index value. The profit from selling the call option was 0.05% per month or 0.60% per year.
This performance gap can have significant implications for your portfolio. For example, $10,000 invested in Invesco QQQ ETF (QQQ) (Nasdaq) in 2014 would have grown to over $50,000 (CAGR 17.65%, Sharpe ratio 0.91). The same amount invested in a QQQ Covered Call ETF like Global X Nasdaq 100 Covered Call (QYLD) would have only grown to $20,000 (CAGR 6.9%, Sharpe ratio 0.52).
Expect covered calls implemented for higher derivative income to result in:
Investors focusing solely on derivative income without considering the holistic picture may lose earning opportunities. This is discussed in details in paper “Covered Call Strategies: One Fact and Eight Myths”.