Generating Passive Income Using Covered Calls

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:

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: