A Step-by-Step Guide To Covered Calls

11 min readOct 3, 2021

Discover The Basics of Covered Calls With Option Experts

Key Takeaways:

Stockholders who think that stock prices are unlikely to rise further in the near future often use a covered call as a way to generate income.

In a covered call, an investor holds a long position in a stock and then sells (writes) call options on the same asset, representing the same size as the underlying long position.

How To Potentially Profit From Covered Calls?

Selling a call option on a stock involves selling someone the right, but not the obligation, to buy 100 shares of the stock at a certain price (the “strike price”) before a certain date (the “expiration date”). You’re getting paid to decrease your flexibility, while they’re getting paid to increase their own.

If you sell covered calls, you get paid an extra amount of money as you hold a stock in exchange for the necessity of selling it at a certain price if it rises too high. That will cap your upside potential, but you will generate high income in the meantime, even in a flat or bearish market.

How To Sell Covered Calls?

Investors who buy stocks at a good price may hold onto them for years even if they become overvalued.

It’s often our opinion to hold positions for years at a time. There is, however, a line in the sand where if a company becomes too expensive, it’s better to sell it and invest in an undervalued company. Continuing to hold companies that you know to be overvalued is seldom the best course of action.

As an alternative, another tactic is “covered call strategies.” In this scenario all investors do is buy stock and sell covered calls on it. Strategies like this are unnecessary typically because no single strategy works for every market condition. For example, you wouldn’t want to sell covered calls when the market is undervalued.

In the right circumstances, covered calls can be quite profitable in the hands of a smart investor. The downside of them is that they limit your upside, so there are times when they aren’t the right tool.

In exchange for giving up a portion of future upside, you get paid when you sell a covered call. As a hypothetical example, assume you buy XYZ stock at $50 each, expecting it to rise to $60 within one year. Additionally, you’re willing to sell the stock at $55 within six months, giving up further upside while taking a short-term profit. In this case, selling a covered call on the position might be an attractive strategy.

Selling a covered call is best when you have already calculated at what price your shares would be overvalued.

By planning this in advance, you don’t have to wait until shares become overvalued before deciding if you should sell them.

If you determine the fair value of businesses you own, you can sell covered calls at strike prices that are substantially higher than those fair values.

As a result, you generate extra income from them while you hold them, and then you sell them when they become significantly overpriced. If that happens, you can redeploy that capital to investments with lower values.

Covered Call-Sell Examples?

Suppose you bought 100 shares of a dividend-paying bank at $30/share years ago when you considered it to be undervalued, and it paid $1/year in dividends out of $2 in earnings per share at the time.

With its dividend yield of 3.33%, the dividend was quite respectable. At the time, the bank had the highest credit rating in its industry, was growing at a respectable pace, weathered the 2008 financial crisis relatively well, and was a good investment at its earnings multiple of 15.

Now that the price is up to $45/share and the dividends are paying $1.25/year, you no longer view it as undervalued.

The stock’s P/E has increased, the dividend yield is only 2.77% due to the stock price increasing faster than the dividend growth, there’s no new catalyst for extra growth for the company, and you wouldn’t buy it today if you wanted to buy a new stock. There’s nothing wrong with the company, but the price isn’t great.

In other words, you’re staying with it because you own it, it’s not overvalued, and if you sell it, you’ll incur capital gains tax unless you’ve put it into a retirement account.

According to the fair price calculator from Option Experts, it is most likely worth less than $42/share:

It might be easier to just stay with the stock for now and collect the low 2.77% dividend yield and maybe enjoy some more price appreciation. However, it is already mildly overvalued, so further growth is unlikely.

If this is the case, selling a covered call on this stock can drastically boost your income from it, along with receiving dividends and capital appreciation.

Here’s A Hypothetical Calculation For A Four Month Option On This Stock:

👉 Strike: This is the price at which you have to sell the shares if the option buyer exercises their option.

👉 Price: This is the price at which the option has been trading recently. An option buyer basically pays the option seller this amount.

👉 Change: These are the recent changes in option pricing.

👉 Bid: If you sell the call, you’ll receive approximately this much in option premiums up front. In return for buying the option from you, the market maker pays you this much.

👉 Ask: A buyer of an option will pay this amount to the market maker to acquire the option. Profit is the difference between the “bid” and “ask” of a market maker. It is his role as a middleman between buyers and sellers that facilitates the market’s liquidity.

👉 Volume: This is the number of option contracts sold today for this strike price and expiration date.

👉 Open Interest: This number represents how many options are available at this strike price and expiration. The total volume of all options that have been traded excluding prematurely closed positions.

Keep in mind 💡

The strike and the bid are the two most important columns for option sellers.

If you exercise the option, the strike is how much you’d agree to sell the shares for, and the bid is roughly how much premium you’d expect to make.

In the graphic above, it’s clear to see there are a variety of options with varying strike prices and premium payments.

There are other pages for other expiration dates, but the graphic only shows one.

For this example, the option with a strike price of $47 stands out in our opinion as a good choice. This is significantly above the current stock price of $45 and offers a decent premium bid price of $0.85.

If you sell this option, you will receive $85 from the option buyer right now, and you will have to sell all 100 shares of this bank at $47 each, for a total of $4,700, before the expiration date of the option in 4 months.

The purchase of several options will obligate you to purchase several hundred shares. There are 100 shares in each option.

As an example, let's assume you sell this option. Option Experts has provided you with this list of inputs and possible outcomes.

Hypothetical Covered Call Scenario 1 ⤵️

Since the market price of the shares is already below $47/share, the option buyer is unlikely to exercise her option if the price stays at $47/share over the next 4 months. Upon expiration, her option will expire worthless, you will keep the $85 premium, you will keep the 100 shares, and you will keep any dividends throughout the holding period.

Now that the option has expired, you are free to sell another one. Due to the 4-month lifespan of the option, this example could be repeated three times in a year.

Its quarterly dividend is currently $0.3125 per share, or approximately $1.25/share annually. The dividends you received may have been one or two, totaling $0.3125 to $0.625 during this option’s 4-month life.

The premiums you collected from this option were $0.85/share, which was far more than just the dividend. The aggregate dividend for $1.25/share over an entire year would be doubled if you sold a similar option three times.

Dividends are currently paid by this company at $1.25/share, or about $0.3125 per share per quarter. You likely received one or possibly two dividends during this 4-month period, amounting to $0.3125 to $0.625 in dividends.

Taking the dividend with the call premiums doubles the dividends in total, so you’ve effectively tripled your dividend yield on the stock.

The stock can rise up to $2/share during the 4-month option lifetime without hitting the strike price, so there is still room for capital appreciation. That would be 4.44% stock growth in 4 months, or 13.33% annualized.

We’ll assume this option expires today at $46, so the stock has increased a buck since 4 months ago, and you have received dividends in addition to your option premium payments.

For your next option sale, you could sell it for $48, so that you can hold it for a longer period. Market premiums will adjust as the stock price moves upward or downward, so if the stock price is $46 and you sell calls for a strike price of $48, you’ll get the same option premium as when the stock price was $45 and the call strike price was $45.

Your dividend yield will be around 2.77% ($1.25/year), and your call premium yield will be about 5.66% ($2.55/year). This means your combined income yield from dividends and options from this stock is 8.44% plus the potential for double-digit capital appreciation up to 13.33% annualized.

The stock price can also drop a bit, maybe to $40 a share or so. The stock is generating huge dividends and options income for you, and you’re holding it for the long term until it goes overvalued.

…& all of this on a nice, stable, blue chip bank with the best credit rating in its industry.

Hypothetical Covered Call Scenario 2 ⤵️

Over the next 4 months, if the bank rises to over $47/share, the option buyer will likely exercise her right to force you to sell her 100 shares at that price. Accordingly, if the stock is trading at $50/share at this point, she can buy them from you for only $47/share.

You’ll receive $4,700 for your 100 shares, as well as the $85 option premium and any dividends paid by the company during that period.

When you’re done, you’ll have:

Capital appreciation of $2/share

Option premiums of $0.85/share

Dividends of $0.625 or $0.3125

…for a total gain of $3.16 to $3.47 per share on your $45/share principle.

This translates into a 7% return over a 4 month period, or 22.5% annualized.

Normally you’d be satisfied with this outcome despite having otherwise been able to sell for a bit more, because now you would consider the stock overpriced, and its dividend yield would be lower than it was at $45 anyway. All these thousands of dollars could be put towards a better investment now. Invest in undervalued stocks instead of overvalued ones.

If the bank were acquired by another company, and its stock price rose dramatically to, say, $60/share, you would probably be unhappy with this outcome. As you would have to sell your shares at only $47, you would lose a lot of that upside. It would be a rare outcome because stable blue chips are only acquired once in a blue moon, and you still had a 7% return over just four months, even if theoretically you could have made more!

In both cases, technically, you can buy back the option you sold if you later decide that you don’t want the obligation to buy (in the case of put options) or sell (in the case of call options), the underlying stock. If the stock price changes, the option could be cheaper to buy back than when you sold it, or it could be more expensive.

Important Always Pay Close Attention To Dividend Dates 🚨

Look up the company’s historical dividend payouts before selling a covered call.

Just go to Google and type, “XYZ dividend history”, where XYZ is the ticker symbol, is the easiest way to do this for us.

It’s usually easiest to locate a company’s dividend history by searching Nasdaq’s page.

Ex/Eff dates, or ex-dividend dates, are the most important dates on the chart. The buyer of the stock does not receive a dividend on those days.

In other words, a buyer of shares of this stock on 9/27/2016 will get the upcoming dividend if you sell the stock. If you sell this stock on 9/28/2016, however, the buyer will be too late and you will receive the dividend. A stock trades “ex-dividend” on 9/28/2016, meaning it does not receive that particular quarterly dividend.

If you own these shares, you should check to see if you’re entitled to dividends during the period prior to selecting the call option you want to sell. As a result, you can estimate what your return on investment might be and what amount you should receive in premiums for taking on the obligation. Dividends may affect option premiums since stock prices usually temporarily drop by the amount of the dividend shortly after the dividend is paid.

Risks of Covered Calls ☢️

If call sellers don’t hold onto underlying shares, they will be holding naked calls, which have a theoretically unlimited loss potential if the underlying security rises. Therefore, sellers must buy back options positions before expiration if they wish to sell shares or contracts, increasing transaction costs while lowering net gains or increasing net losses.

Bottom Line 📈

Covered call options can be a powerful strategy, but only in the right situation. The right tool for the right task can be extraordinarily useful, but can also be harmful or useless in the wrong hands.

Covered call buy-writing strategies that are gimmicky are not necessarily the best option.

Covered calls are best sold at the following times:

1) When the market is overvalued and likely to be flat or down for a while. Options and dividends can still generate a lot of income during prolonged bear markets.

2) For slow growth companies, so you can maximize your returns from both dividends and call premiums as well as capital appreciation from buybacks and slow organic growth.

3) When one of your stock holdings becomes expensive compared to its fair value. If you want to get some extra income and returns from your stock before it gets overvalued, sell covered calls at strike prices well above its fair value estimate. Ultimately, if it ends up crossing your strike price and you must sell it, you can redirect the capital you saved to invest in more undervalued investments.

You can find more information at Option Experts. There are tools and software calculators available that can help you determine stocks’ fair value and determine which options you should sell.