Picking the right covered call strategy to generate income on the stocks you own

Published Thu, Feb 15 202410:12 AM EST

Selling covered calls is a popular options trading strategy, especially among investors looking to generate additional income from their stock holdings. The strategy involves selling call options on stocks that the investor already owns. Like any investment strategy, selling covered calls comes with its own set of risks and benefits. The benefits Income generation: The primary benefit of selling covered calls is the ability to generate income on your stock holdings. The seller receives an upfront premium from the buyer of the call option, which can provide a steady income stream in flat or slightly bullish markets. Downside protection: The premium received can also offer modest protection against a decline in the stock's price. This benefit is often overstated in my view, and I prefer to think of it differently. Over time, generating income in the form of options premiums smooths returns in much the same way that preferred dividends or bond coupons do in fixed income portfolios. Portfolio management: Some investors use this strategy to collect premium at pre-determined prices where they would otherwise exit positions anyway. If the stock price rises above the strike price, the stock may be called away, allowing the investor to realize gains with a little extra income as well. (Similarly, selling cash-covered puts is sometime used at prices where an investor is interested in entering a stock.) The risks Limited upside potential: If the stock's price exceeds the strike price of the covered call, the seller misses out on any gains above the strike price plus the premium received. Assuming the seller doesn't buy back the call before expiration, the stock will likely be called away at the strike price, capping the seller's profit. Stock ownership required: A covered call strategy, by its nature, assumes the call seller owns the underlying stock, which means the investor is exposed to the risks associated with holding stocks, including the possibility of a significant decline in the stock price. While some more advanced options traders may sell "naked" calls — short calls which are not offset by either a long position in the underlying or another long call option — covered calls assumes the short call position is offset by another long position in the underlying. Potential for Assignment: There's always a risk that the option could be exercised by the buyer before expiration (assignment risk), leading to the stock being called away. This is more likely if the stock price exceeds the strike price significantly before the option's expiration date, particularly if the stock pays a dividend, in which case call holders may exercise their options prior to an ex-dividend date so that they may collect the dividend as only the holder of record of the stock, not the holder of options, is entitled to the dividend. Candidates for selling covered calls Stocks with moderate growth expectations: Stocks that are expected to grow steadily but not explosively are good candidates. The strategy works best in a flat to slightly bullish market. Dividend-paying stocks: Selling calls on dividend-paying stocks can be particularly attractive because it allows the investor to potentially enjoy both the dividend income and the option premium, bearing in mind that if the stock appreciates above the strike price materially, one may want to "cover" (buy back) the short-call prior to the ex-dividend date to avoid assignment. Stocks with high option premiums: Stocks that have high implied volatility (and thus higher option premiums) can provide higher income from the premiums, making them attractive for covered call strategies. This comes with an important caveat though. Simply screening for stocks with high options premiums alone is not advisable because often options prices are elevated for good reason. For example, options premiums are generally higher going into a catalyst that could cause a price to move sharply, such as an earnings announcement. Other considerations: Options decay accelerates as expiration approaches, so it is important to consider both the premium collected and the time to expiration, rather than just trying to maximize the premium itself. Trading examples To understand this consider the following three covered calls, all on the same stock, Micron (MU) . The first trade, a March $82.5 call collects $3.20, or 3.9% of the current stock price between now and March expiration, 30 days away. The second trade, a July 82.5 call at 8.40 collects almost 10.3%, but expires in 156 days. The third trade, selling the January 2025 82.5 call at $13.25 collects nearly 16.2% of the current stock price and expires in 338 days. One way to think about the relationship between the premiums collected and the expirations is to annualize those standstill rates of return. So 365 calendar days / 30 days x 3.9% is ~ 47.54% annualized for the July call. 365/156 x 10.3 = ~24.1% annualized for the July call and 365/338 x 16.2% ~ 17.5% annualized for the January call. Doing this calculation we quickly see that if we assumed Micron's share price didn't move, we would be better off selling the 1 month 82.5 calls and then rolling and selling the following month at expiration, again and again. The problem with this though is that of course Micron shares WILL move. If they move sharply lower, we'll still collect the 3.9% in premium, but would we be comfortable selling a lower strike call, perhaps at a strike lower than where we purchased the shares in that event? It demonstrates that a more frequent / shorter dated covered call strategy's success if more dependent upon the price path of the underlying stock. It also introduces some logistical complexity - as investors are we prepared to roll covered calls weekly if weekly options are listed? That may be more trading activity than some investors are prepared for. So what to do? For those starting out, I generally favor selling covered calls with less than 90 days to expiration, this improves the rate at which premium is collected. Another reason I prefer options that expire in less than 90 days is because I do not generally encourage investors to sell covered calls through an earnings event when they are first starting out with the strategy. Another example Earnings can provide new information to the investors that causes a price jump (or gap downwards). Consider the following chart of Eli Lilly & Company. This has not historically been a very volatile stock, but you'll observe that when the company reported earnings in August of 2023 the stock jumped nearly 15% immediately, and followed through in the days ahead with further gains. The reason? Investors began to appreciate the impact of the company's obesity and diabetes drugs. Diabetes related revenue grew 26% in just 6 months from just under $4 billion for Q4 '22 to over $5 billion in Q2 '23. Looking at the chart is is easy to see that collecting slightly fewer and smaller premiums prior to earnings would have been wiser than trying to collect slightly larger options premiums through earnings and sacrificing the substantial gains in the share price. Consequently, I tend to favor selling covered calls in companies that have revenues growing at between 5-15%, somewhat steadily. I prefer to sell covered calls only in companies that are investment grade (S & P rating of BBB- or better), and of course, for the most part, avoiding selling covered calls through earnings. For what it's worth, the Micron Technologies March covered call does meet most of the criteria. Earnings are expected on March 28th, 42 days away, which is after (regular) March expiration. Additionally the stock is up nearly 33% over the past 52 weeks, so unless one purchased the shares in the early 2021 or early 2022 time frame, the cost basis is likely lower than the current stock price. Micron's debt is rated BBB- by S & P, meaning it is "investment grade", albeit the lowest tier. Some folks also like to "trade around" their positions, so if the stock falls and they can repurchase the calls at a fraction of the price where they were sold, they will do so and look for a rebound to reinitiate the covered call, and assuming one own's Micron shares and elects to sell the covered call, if the stock falls and the call can be covered for ~ 25% of the price at which it was sold, with more than a week remaining to expiration, I recommend doing exactly that. Buy it back at that time and look for an opportunity to reload, possibly following earnings. DISCLOSURES: (None) THE ABOVE CONTENT IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY . THIS CONTENT IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSITUTE FINANCIAL, INVESTMENT, TAX OR LEGAL ADVICE OR A RECOMMENDATION TO BUY ANY SECURITY OR OTHER FINANCIAL ASSET. THE CONTENT IS GENERAL IN NATURE AND DOES NOT REFLECT ANY INDIVIDUAL'S UNIQUE PERSONAL CIRCUMSTANCES. THE ABOVE CONTENT MIGHT NOT BE SUITABLE FOR YOUR PARTICULAR CIRCUMSTANCES. BEFORE MAKING ANY FINANCIAL DECISIONS, YOU SHOULD STRONGLY CONSIDER SEEKING ADVICE FROM YOUR OWN FINANCIAL OR INVESTMENT ADVISOR. Click here for the full disclaimer.