The Ultimate Guide To Selling Covered Calls

Covered calls can turbocharge your portfolio's returns, here's how you can take advantage

December 05, 2022

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Today we’ll explore how to maximize your portfolio's returns by using the covered call strategy.

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The Ultimate Guide To Selling Covered Calls

Highlights

  • Covered calls are a conservative options trading strategy that can provide income from the stocks you already own

  • There are five "Greeks" that drive the behavior of an options contract

  • There are four possible outcomes when selling covered calls

Today we're going to explore covered calls and how we can maximize the value of our portfolio holdings.

Covered calls are a conservative options trading strategy that allows you to receive income from the stocks you're already holding. You can receive income from covered calls as often as daily and it can combine with your dividend income to provide a super strong passive income stream.

Unfortunately, most people don't try to use options to bolster their income.

They believe options trading is "too risky."

  • They tried to trade options before and lost badly

  • They don't understand what options are

  • They've never even heard of options

But today we're going to change that. By the end of this issue, you'll be able to understand covered calls and implement them in your portfolio.

Here's how to sell covered calls step by step:

Step 1: Understand What A Call Option Is

To sell covered calls, you have to understand what call options are and how they work.

A call option is a contract that gives the buyer the opportunity to buy 100 shares of a stock at an agreed-upon price. The seller (in this case, you) must hold 100 shares of the stock and has to sell the 100 shares if the stock reaches the agreed-upon price.

As soon as you sell the contract, you collect what is known as a premium.

The people buying your covered call are likely short sellers at big investment firms that are trying to hedge their short positions with call options.

Step 2: Learn The Greeks

The Greeks are the numbers that drive the behavior of an options contract.

There are 5 "Greeks" in total: Delta, Gamma, Theta, Vega, and Rho.

I recommend learning all of them, but for our purposes today we will be focusing on Delta and Theta.

Delta represents the sensitivity of an options price to changes in the value of the underlying security.

Delta is commonly used as the chance that a contract ends "in the money" (stock price meets or exceeds strike price). 

For example, if an option has a Delta of 0.1944, that means there's a 19.44% chance the option will end in the money.

Theta is the measure of how much an option should decrease in value after the day is done. 

Theta should increase the closer you move to the expiration date of the contract.

For example, if Theta is -0.0597, the options contract should decrease in value by roughly $0.06 by the close of business that day.

Here's what the Greeks look like in an options contract:

Step 3: Hold 100+ Shares Of A Stock

The difference between selling a call and a covered call is having 100 shares to cover the contract.

Let's say we sold a covered call and the stock ends in the money. The buyer of our covered call will exercise the option and get our 100 shares at the agreed-upon price. If we didn't have those 100 shares and our call wasn't "covered", we would be on the hook for the price of those 100 shares. If you sold a contract on Apple (AAPL), that would be roughly $15,000. Not something I'd want to come out of pocket for.

Options can be as risky as you want them to be, and selling calls that aren't covered is certainly a risky tactic.

Step 4: Sell A Covered Call At A Delta You're Comfortable With

Investors often pick a Delta that is too high and end up having the options contract exercised, calling away their shares.

Investors often chase higher options premiums but with those higher premiums comes a higher chance that the stock ends in the money and shares are called away.

To combat this, pick a contract at a Delta you're comfortable with (for me it's between .15 - .25).

Covered Call Outcome Scenarios

When selling covered calls, there are 4 possible outcomes, let's take a look at each.

1. Stock ends in the money.

Let’s say you sell a covered call on Starbucks today for a $108 strike price. If the stock closes at $108 or higher, you sell 100 shares at $108.

Make sure your average cost is under $108 so you can profit from this transaction!

2. Stock goes on a run. 

This one stings.

Let’s stick with our $108 Starbucks example, if Starbucks goes on a run and closes on Friday at $115, you still have to sell at $108 and you miss all that potential profit. It’s part of the game but you can always buy back in and rinse & repeat.

3. Stock does not end in the money.

This is an ideal outcome.

The stock doesn’t reach the $108 strike price, you keep your 100 shares & the premium. You can also go right back to selling another covered call for the next week.

4. Stock’s price crashes.

Covered calls do not offer any downside protection.

If the stock’s price were to tank, you have the option of waiting it out or adding to your position at this lower price to bring down your average cost. You then could sell a covered call at a lower strike price.

Some Tips I Use To Sell Covered Calls 

• ALWAYS sell above your cost basis. It's not worth locking in 100 shares as a loss.

• Pick a Delta between .15 - .25

• Look for a 2-4% monthly return from premiums on the cost of your 100 shares (example: if you have $100 of shares in XYZ company, aim to make about $2-$4 per month from covered calls)

• Sell on Fridays if you can to maximize Theta decay

• Sell on green days because contracts become worth more

• Hold an extra 10 shares so if the stock goes on a run, you can still profit

Final Thoughts

Covered calls can turbocharge your portfolio's ability to produce passive income.

By understanding options, learning the greeks, and selling those covered calls, you can create an additional income stream from your portfolio. Covered calls when added to dividends can be a powerful one-two punch that takes your portfolio to the next level.

The best part about covered calls is that no matter how the contract ends, you still collect the premium no matter what. That premium can be reinvested into more shares of companies or spent however you like.

Enjoy your newfound income stream!

Links & Memes

Someone asked AI to write a biblical verse about removing a peanut butter sandwich from a VCR. Not only did it make me laugh hysterically, but it made me think: if this is possible for AI, what's next?

This made me chuckle:

As a longtime fan of the show Shark Tank, this made me die laughing:

Some filthy goals by French star Kylian Mbappe:

One of my favorite creators Jack Butcher was featured at Art Basel in Miami, Florida. I think he perfectly encapsulates what it looks like when we trade time for money. This is why I invest:

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