Generating passive income and protecting profits using covered calls

What is a covered call?

A covered call is an options strategy wherein call options are sold against stocks already owned by the investor. By owning the stock, you mitigate the risk of delivering shares if the option is exercised in-the-money. The sale of the covered call generates an income stream, or premium, adding to the appeal of this low-risk strategy. Many professional traders opt to sell calls against a section of their holdings, allowing for potential upside on the remaining assets or the chance to sell more calls at a higher strike if the stock price escalates.

How does it work:

Covered calls are favored by traders who maintain medium to long-term equity positions. While selling calls can carry the risk of unlimited losses if the stock price surpasses the strike price, those losses can be curtailed by delivering the owned stock to the option buyer upon option expiry or exercise.

The covered call option expiration:

If the stock price is greater than the strike price at expiration, the option is in-the-money (ITM) and the seller must deliver the stocks to the option buyer. The owned shares in your portfolio offset against the ITM option. As a seller, you retain the premium, while the option buyer acquires the stock at the option's strike price.

If the stock price is less than the strike price, the option is out-of-the-money (OTM). The option seller has no obligation to deliver stock to the buyer, and the option expires worthless for the buyer. The seller retains the premium.

Example:

Suppose you own 1000 shares of stock A priced at £30 and the current price is £35. If you're content to sell stock A at £40, you can sell 10 call options at a £40 strike price expiring in a month (Each call option lot equates to 100 shares of the underlying stock). Assuming these are trading at about £0.70, you receive a premium of 10 call options x 100 shares x £0.70 = £700.

Scenario analysis:

Ideal times to trade covered calls:

Covered calls best serve in sideways or down-trending markets, generating income from premiums while maintaining long equity portfolios. In a strong uptrend, selling covered calls might sacrifice further upside potential for a relatively small premium. In such cases, you could stagger your sales – selling two lots in five batches. The implied volatility of the option also factors in – higher implied volatility equates to greater premiums.

Benefits of covered calls:

• Generates passive income via premiums, supplementing the overall portfolio return
• Low-risk strategy with no extra margin needed to sell covered calls, given the underlying stock is held for delivery

Covered call trading risks:

• Caps your stock's upside potential
• Risk of using covered calls as take profit orders proxy: In the example above, if the stock trades well above £40 during the option's lifespan but falls below £35 at expiry, the profit would have been locked at £40 without the option

Key points when trading covered calls against CFDs:

To avail a margin offset when selling covered calls, owning the underlying shares is a must. Calls against CFDs still incur additional margin for the option. CFD holdings cannot be delivered to the call option buyer if the option expires in-the-money. For CFD holders, one alternative is to switch the CFD with stock (sell CFD, buy stock) nearer to the expiry date if the option is likely to expire in-the-money.