What Are Covered Calls?

A covered call is a call option you sell on a security that you already own. Investors use covered calls to generate additional income from stocks that they own in their portfolio.

Let’s look at the January 2013 option chain for SandRidge Energy (SD) to see just how much income you could generate from the shares by selling covered calls:

Looking at the “bid” column for the most liquid options, we find that we can sell covered calls at the $7.50, $9, and $10 strike prices, which will net 55, 13, and 6 cents per option respectively.

Picking a Strike Price for a Covered Call

The hardest part of using covered calls to generate an income is picking a strike price at which you want to sell call options.

When you sell a covered call option, you are selling the right to acquire your shares at a predetermined price sometime in the future. Thus, if you were to sell 100 calls at the $9 strike for SandRidge Energy, the buyer would have the right to acquire your shares for $9 at any point from October 6, 2012 (the date this article was written) to January 19, 2013. In exchange, you receive $.13 per call option sold as a premium for the option.

Suppose that you decide to sell 100 covered call options at a $9 strike against the 100 shares you own.

There are two possible outcomes:

1. SandRidge does not rise above $9 per share by the January 2013 expiration date, and the options the buyer purchased expire with zero value. You get to keep the $.13 per option sold. If SandRidge Energy rose to $8.50, you would still own your shares, as the options would not be exercised. Thus, you earn $.13 per share for each option ($13 in total), and retain ownership of 100 shares valued at $850.
2. SandRidge trades above $9, and the options are exercised. You get to keep the $.13 in option premiums, but your shares are sold at $9. If SandRidge Energy rose to $10 per share by January, you would have sold for a total price of $913 (100 shares at $9, plus 100 options at $.13). You would have given up $87 in profits, however, since your shares had a market value of $1,000.

You can see how covered calls affect your investments. On one hand, you get the covered call premium regardless of the outcome, earning $13 on your stock worth $727. On the other hand, you risk giving up some of your upside should the stock rise in value quickly before the expiration date.

Said another way, you make money when the underlying stock fails to rise to a value greater than the sum of the per share price plus the option price ($9.13 in the example). You lose money with covered calls when the stock rises above the sum of the per share price plus the option premium ($9.13 in the example).

Covered Calls in an Ideal World

In a perfect setting, an investor would always sell call options at a strike price that is high enough that the options are not exercised. In such a case, the investor would receive regular streams of income from selling covered calls while never having to sell his or her stock at a price less than market value.

The best way to use covered calls to generate an income is to sell calls only at a strike price at which you would be comfortable selling your shares. If you had a goal to sell your SandRidge shares at a price of $9, then selling covered calls in January at the $9 strike makes perfect sense. You make $13 in premiums for agreeing to sell your shares at $9, something you wanted to do anyway.

Covered calls are tricky in that they force the investor to be bullish about a stock (why else would you own it?) but also cautious about its potential (you wouldn’t sell a covered call at a strike price less than you think it is worth.)

For the enterprising investor who has a concrete exit plan for every position, covered calls are a great way to make money while setting a firm take profit price. However, for an investor with limited experience in the market, and with only a rudimentary understanding of their investments, covered calls can be a disaster by limiting returns in exchange for a relatively small premium from the sale of a covered call.