Generating Passive Income Using Covered Calls

Option
Danny Khoo

Sales Trader

What is a covered call?
A covered call is an option strategy that involves selling  call options against a stock that you already own. As you own the stock, the risk of delivering the shares if the option expires in the money is covered. At the same time, the seller of the call option will generate some passive income (premium) in the process of selling the covered call. This is considered to be a lower risk option strategy as the risk of unlimited loss is capped. Typically the professional traders tend to sell calls against a portion of their holdings at one time so that they can participate on the upside on the remaining holdings or have the opportunity to sell more calls at a higher strike if the stock price goes up further.

How does this work?
Selling covered calls is a popular strategy for traders who hold equities over the medium to long term. Typically, selling calls are risky as it exposes a trader to unlimited losses if the underlying stock price goes up above the strike price. However, if a trader already owns the underlying stock, the losses can be limited by simply delivering the stock to the option buyer upon expiry or when the option buyer exercises.

What happens at the expiration of the covered call option?
1. If stock price > strike price on the expiration day, the option is in the money (ITM) and therefore the seller of the option is obligated to deliver the stocks to the buyer of the option. When you own the shares in your portfolio, they get offset against the option expiring in the money. As an option seller, you get to keep the premium and the option buyer gets the stock at the strike price of the option. Some traders like to think of it as a pre-agreed cap on profit on the stock in exchange for a premium.

2. 
If stock price < strike price, the option is out of the money (OTM) and there is no obligation for the option seller to deliver the stock to the buyer of the option. The option expires worthless for the buyer and the seller gets to keep the premium.

For example:
Let’s say you own 1000 shares of stock A at $30 and current price is $35.

If you feel comfortable selling stock A at $40 if it gets to that price, you can place an order to sell 10 call options at strike 40 expiring in a month’s time (For US shares, each lot of call option represents 100 shares of the underlying). Let’s assume this is trading at about $0.70. As a result, you will receive premium for 10 call options x 100 shares x $0.70 = $700

Scenario analysis:

Goes above $40
You sell your 1000 shares of stock A at $40, making a profit of $10 per share. Total gain = your premium received ($700) + your profit ($10 x 1000 = $10,000) 
 Does not go to $40Total gain = your premium received ($700) from selling 10 call options at $40 strike. There is no obligation to sell your shares to call option buyer.

When are the best times to trade covered calls?
The best time to trade covered calls is in a sideways or down trending market where you can generate good income from premiums while holding onto your long equity portfolio. In a strong uptrend, it might be less optimal to sell covered calls and give up further upside potential for a relatively small premium. If you wish to do so, it might make sense to do it in multiple tranches – instead of selling 10 lots of calls at once, you can stagger into 5 batches of 2 lots and sell on the way up. The other important input to consider is the implied volatility of the option – the higher the implied volatility, the greater the premium for the option.


Key advantages of covered calls
1. Generates passive income. Selling a covered call generates an income via premiums that can supplement the overall return of a portfolio.

2. 
Relatively low risk. As the risk of being short a call is covered with your stock position, this is a relatively low risk way to trade options.

3. 
No extra margin required to sell covered calls. As you hold the underlying stock for delivery, there is no extra margin required to sell the same number of covered calls at Saxo.


Risks of trading covered calls
1. Capping your stock’s upside potential. One key risk is the loss of opportunity to profit from your stock’s potential upside above the call option’s strike price.

2. 
Risk of using covered calls as a proxy for take profit orders: In the example above, it is possible that the stock trades well above 40 through the course of the option but on expiry falls back below 35. Without the option, the stock holder might have booked the profit at 40 but because the stock was covered by call options, the stock holder might have waited out until expiry.

Key points to note when trading covered calls against CFDs:
1. To enjoy a margin offset for selling covered calls, you will need to own the underlying shares. Selling calls against CFDs would still incur additional margin for the option.

2. 
It is important to note that CFD holdings cannot be delivered to the call option buyer if the option expires in the money.

3. 
One of the alternatives for CFD holders is to replace the CFD with stock (sell CFD, buy stock) closer to the expiry date if the option is likely to expire in the money.

Scenario analysis on expiry of the option:

Selling against the full holdings of 1000 shares
Selling against half the holdings of 500 shares

Quarterly Outlook

01 /

  • Macro Outlook: The US rate cut cycle has begun

    Quarterly Outlook

    Macro Outlook: The US rate cut cycle has begun

    Peter Garnry

    Chief Investment Strategist

    The Fed started the US rate cut cycle in Q3 and in this macro outlook we will explore how the rate c...
  • Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges

    Quarterly Outlook

    Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges

    Althea Spinozzi

    Head of Fixed Income Strategy

  • Equity Outlook: Will lower rates lift all boats in equities?

    Quarterly Outlook

    Equity Outlook: Will lower rates lift all boats in equities?

    Peter Garnry

    Chief Investment Strategist

    After a period of historically high equity index concentration driven by the 'Magnificent Seven' sto...
  • FX Outlook: USD in limbo amid political and policy jitters

    Quarterly Outlook

    FX Outlook: USD in limbo amid political and policy jitters

    Charu Chanana

    Chief Investment Strategist

    As we enter the final quarter of 2024, currency markets are set for heightened turbulence due to US ...
  • Commodity Outlook: Gold and silver continue to shine bright

    Quarterly Outlook

    Commodity Outlook: Gold and silver continue to shine bright

    Ole Hansen

    Head of Commodity Strategy

  • FX: Risk-on currencies to surge against havens

    Quarterly Outlook

    FX: Risk-on currencies to surge against havens

    Charu Chanana

    Chief Investment Strategist

    Explore the outlook for USD, AUD, NZD, and EM carry trades as risk-on currencies are set to outperfo...
  • Equities: Are we blowing bubbles again

    Quarterly Outlook

    Equities: Are we blowing bubbles again

    Peter Garnry

    Chief Investment Strategist

    Explore key trends and opportunities in European equities and electrification theme as market dynami...
  • Macro: Sandcastle economics

    Quarterly Outlook

    Macro: Sandcastle economics

    Peter Garnry

    Chief Investment Strategist

    Explore the "two-lane economy," European equities, energy commodities, and the impact of US fiscal p...
  • Bonds: What to do until inflation stabilises

    Quarterly Outlook

    Bonds: What to do until inflation stabilises

    Althea Spinozzi

    Head of Fixed Income Strategy

    Discover strategies for managing bonds as US and European yields remain rangebound due to uncertain ...
  • Commodities: Energy and grains in focus as metals pause

    Quarterly Outlook

    Commodities: Energy and grains in focus as metals pause

    Ole Hansen

    Head of Commodity Strategy

    Energy and grains to shine as metals pause. Discover key trends and market drivers for commodities i...
Disclaimer

Saxo Capital Markets (Australia) Limited prepares and distributes information/research produced within the Saxo Bank Group for informational purposes only. In addition to the disclaimer below, if any general advice is provided, such advice does not take into account your individual objectives, financial situation or needs. You should consider the appropriateness of trading any financial instrument as trading can result in losses that exceed your initial investment. Please refer to our Analysis Disclaimer, and our Financial Services Guide and Product Disclosure Statement. All legal documentation and disclaimers can be found at https://www.home.saxo/en-au/legal/.

The Saxo Bank Group entities each provide execution-only service. Access and use of Saxo News & Research and any Saxo Bank Group website are subject to (i) the Terms of Use; (ii) the full Disclaimer; and (iii) the Risk Warning in addition (where relevant) to the terms governing the use of the website of a member of the Saxo Bank Group.

Saxo News & Research is provided for informational purposes, does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. No representation or warranty is given as to the accuracy or completeness of this information. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. No Saxo Bank Group entity shall be liable for any losses that you may sustain as a result of any investment decision made in reliance on information on Saxo News & Research.

To the extent that any content is construed as investment research, such content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication.

None of the information contained here constitutes an offer to purchase or sell a financial instrument, or to make any investments.Saxo Capital Markets does not take into account your personal investment objectives or financial situation and makes no representation and assumes no liability as to the accuracy or completeness of the information nor for any loss arising from any investment made in reliance of this presentation. Any opinions made are subject to change and may be personal to the author. These may not necessarily reflect the opinion of Saxo Capital Markets or its affiliates.

Please read our disclaimers:
- Full Disclaimer (https://www.home.saxo/en-au/legal/disclaimer/saxo-disclaimer)
- Analysis Disclaimer (https://www.home.saxo/en-au/legal/analysis-disclaimer/saxo-analysis-disclaimer)
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)

Saxo Capital Markets (Australia) Limited
Suite 1, Level 14, 9 Castlereagh St
Sydney NSW 2000
Australia

Contact Saxo

Select region

Australia
Australia

The Saxo trading platform has received numerous awards and recognition. For details of these awards and information on awards visit www.home.saxo/en-au/about-us/awards

Saxo Capital Markets (Australia) Limited ABN 32 110 128 286 AFSL 280372 (‘Saxo’ or ‘Saxo Capital Markets’) is a wholly owned subsidiary of Saxo Bank A/S, headquartered in Denmark. Please refer to our General Business Terms, Financial Services Guide, Product Disclosure Statement and Target Market Determination to consider whether acquiring or continuing to hold financial products is suitable for you, prior to opening an account and investing in a financial product.

Trading in financial instruments carries various risks, and is not suitable for all investors. Please seek expert advice, and always ensure that you fully understand these risks before trading. Saxo Capital Markets does not provide ‘personal’ financial product advice, any information available on this website is ‘general’ in nature and for informational purposes only. Saxo Capital Markets does not take into account an individual’s needs, objectives or financial situation. The Target Market Determination should assist you in determining whether any of the products or services we offer are likely to be consistent with your objectives, financial situation and needs.

Apple, iPad and iPhone are trademarks of Apple Inc., registered in the US and other countries. AppStore is a service mark of Apple Inc.

The information or the products and services referred to on this website may be accessed worldwide, however is only intended for distribution to and use by recipients located in countries where such use does not constitute a violation of applicable legislation or regulations. Products and Services offered on this website is not intended for residents of the United States and Japan.

Please click here to view our full disclaimer.