Generating Income With Covered Calls

By TradeSmith Editorial Staff

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Between 1970 and 1980, the S&P 500 gained a whopping 19.5%.

We saw more than that between the start of January last year and the end of August, a total of eight months.

Right now, there’s plenty of speculation that we could be in for a period of stagflation, where markets largely move sideways.

As investors, we need to be prepared for every type of market. And sideways markets are no exception.

Covered calls work exceptionally well in this environment.

This basic options trade allows you to collect premiums on stocks you own (and if they’re dividend stocks, you’d still receive those dividends while holding your shares).

As one of the most fundamental options strategies out there, you need to understand how covered calls work.

Today’s newsletter will walk you through the basics and give you some tips on how to get the most out of these trades.

Buying versus Selling Calls

A call option gives the contract’s owner the right to buy stock from the seller at a given price, known as the strike, up to a specified date, known as the expiration.

If you sell someone a call contract, you give them the right to purchase 100 shares of stock from you up until expiration at the agreed upon strike price.

For example, if I sell someone a call option to buy 100 shares of Apple (AAPL) at $100 that expires in three months, the owner of that option can exercise that right at any time over the next 90 days if AAPL goes to $100 or more.

Now, no one would want to buy 100 shares of Apple at $100 if the stock is trading at $90.

But once shares climb above $100, the option owner can now buy 100 shares of stock from me at $100 and immediately turn around and sell them in the open market.

The amount a stock moves above a call option’s strike price is what’s known as “in the money” or “moneyness.” This refers to the value of that option if the owner executed the contract immediately, bought the shares from me at $100, and sold them in the open market.

If Apple traded at $102, my $100 call option would be $2 in the money.

This is also referred to as intrinsic value.

Any stock that isn’t in the money has no intrinsic value. A $100 Apple call option has no intrinsic value when Apple trades at $90 per share.

However, that doesn’t mean the option has no value.

In fact, the remaining value, known as extrinsic value, is what we’re going to focus on.

Extrinsic value is what’s referred to as the “time value” of an option.

It’s the amount of an option’s price that decays at an exponential rate over time until you get to expiration.

And this is what we want to focus on and maximize when we sell covered calls.

Basics of Covered Calls

At its core, covered calls involve two actions:

  1. You purchase (or already own) stock in multiples of 100.
  2. You sell a call option against those shares.
Here’s how it works.

Let’s say I buy 100 shares of Dow Inc. (DOW), which pays a 4.76% dividend yield, or $2.80 per share annually.

The chart below graphs the high, low, open, and close for each week over the last couple of years.

Source: Tradingview

Shares of Dow Inc. made a high in May 2021 at $71.38.

Since then, shares have drifted lower, and are now trading in a range of roughly $52 to $62 since the start of the year.

We know that if we sell a call contract against the shares we own, the purchaser will have the right to buy that stock until expiration at that strike price. As long as the stock stays below that price, the purchaser is not able to exercise the contract.

So, what would happen if we sold a call option at $72.50?

Option prices are made up of three components:

  1. The distance between the stock’s current price and the strike price
  2. The amount of time left until expiration
  3. Implied volatility
Let’s take a look at an option chain for Dow Inc..

Source: Thinkorswim by TD Ameritrade

The option chain above lists the call options for the Jan. 20, 2023, expiration.

Right now, the Jan. 20 $72.50 call option is selling for $1.55.

That expiration is 319 days from this writing. Let’s call it a full year and assume we can also collect a year’s worth of Dow’s dividends during that time.

If we owned 100 shares of Dow Inc., we could sell the $72.50 call option that expires in January 2023 for $1.55 or $155 per contract. Each option contract controls 100 shares of stock.

Adding the dividend payment and the call option payment together we get:

$1.55 + $2.80 = $4.35

Let’s say we bought shares today at $58. If we collect dividends and the call premium, our return on investment is:

$4.35 / $58 x 100% = 7.5%

Keep in mind, this excludes any gains the stock makes between $58 and $72.50, which is another 25% should it happen.

Now, let’s say that I want to get a little more aggressive. Instead of looking out to January of next year, I want to go with June of this year. Plus, I’m going to lower my strike price to $65. Here is the option chain for that expiration.

Source: Thinkorswim by TD Ameritrade

The call option that expires on June 17, 2022, 102 days from this writing, trades for $1.60.

If I went with that expiration, I’d likely only receive one of the four dividend payments from Dow Inc.

But, I would make $1.60 per option or $160 in a much shorter amount of time.

Between the dividend and the sale of the call option I could expect to make:

$1.60 + ($2.80 / 4) = $2.30

Annualized, this would equate to a return on investment of:

$2.30 / $58 x 100% = 3.97%

(3.97% / 102 days) x 365 days = 14.19%

The main difference between this call option and the one in our January example is that this one is at the $65 strike price while the January one is at $72.50.

Because the June option is closer to the current price, it is more likely the stock will reach our strike before expiration. However, that’s offset by giving it only 100 days to reach the strike price rather than a full year.

This illustrates the tradeoff between time until expiration and distance between the strike price and the price of the stock.

So, the maximum gain I could get on top of the options and dividends would be another 12.1% since I cut myself off at $65 instead of $72.50.

The Best Time to Sell Covered Calls

Now your first thought is probably to sell call options that have a strike price closer to the stock’s current price.

However, the narrower the distance between the two, the more likely you are to have the stock’s price exceed the strike price and have your shares called away (bought by the call option owner).

Instead, we want to sell call options when implied volatility is high.

The higher the implied volatility is, the higher the option price will be.

Plus, implied volatility is mean-reverting, which tells us that as implied volatility moves toward extremes, both high and low, the odds increase that it will move back toward its historical average.

So, by selling covered call options when implied volatility is high, we use that contraction in implied volatility to work for us.

Let’s go back to our last example with Dow Inc. and the June expiration.

Assume that right now, implied volatility is very high.

Also assume that tomorrow, implied volatility drops significantly, so that $1.60 price may drop down to $1.20.

Essentially, you just got $0.40 of price movement in your favor just from the drop in implied volatility.

The best part is you can close the covered call option early at $1.20 or any lower price, take those quick profits, and maximize your potential gains.

Now that you’ve got the basics down, how do you plan to use covered calls to generate income?

Email me and let me know.

While I can’t respond to every message, I promise to read them all.