Covered Calls
For conservative investors, selling calls against
long stock position can be an excellent way to generate income.
| Example | Increase in Volatility | Time Erosion |
| buy stock sell call |
little impact on position | helps position |
Earning Income on Your Portfolio
Let's imagine that you've owned Bubba Gump's stock for years. After multiple stock splits, you now have 1,000 shares. Pleased with the overall growth rate, you decide to hold the stock rather than sell it. Rather than just sitting back in a traditional buy and hold position, you decide to use options to generate some additional income (cash flow) at very little risk to you. For example, with the stock at $31 you could sell five 35 calls for the current month at $2. Actually, you could sell as many as ten 35 calls and still be covered (you own 1000 shares), but for this example let's be conservative and sell only five.
Knowing the stock price hasn't fluctuated much; you might have confidence that it isn't going to move higher than $35 in the before expiration. After all, that would be a more than 10% move. At expiration, if the stock is still below $35, you keep the $1,000 you received by selling the calls, as well as your stock. At that point, you might decide to write (sell) a few more calls for the next month.
Should the stock rise unexpectedly above $35, and stay above $35 on expiration, you will have two choices. You can either buy the calls back and keep the stock. Or, you can let the stock be called away and sell 500 shares (5 contracts x 100 shares) at the strike price of $35. The good news, in this case, is that you still own 500 shares and you participated in the rise from $31 to $35 on the 500 shares you sold at 35. In doing so, you locked in an additional $2,000 in profit.
| Stock Price | Position at Expiration* |
Position Value at Expiration |
| $29 | Long 1,000 shares | 30,000** |
| $32 | Long 1,000 shares | 33,000** |
| $35 | Long 1,000 shares | 36,000** |
| $38 | Long 500 shares | 37,500*** |
| $41 | Long 500 shares | 39,000*** |
This example does not factor in commissions, interest or tax consequences.
* Above $35, this assumes that the options were assigned and 500 shares were sold at $35.
**Includes $1,000 from the initial sale of calls.
*** Includes $18,500 in cash. $17,500 from selling 500 shares at $35 and $1,000 from the initial sale of calls.
Using Current Month Options
When writing covered calls, most investors tend to sell current (near) month options for two reasons. First, the earlier the expiration, the less opportunity the stock has to trade through the strike price. Second, and equally important, is the role time decay plays in the value of the options. Like all out-of-the-money options, the 35 calls in the example above have no intrinsic value. As such, the only value is the time premium or time value which, in the final month of expiration, decays more and more rapidly. For these reasons, investors often sell options that have one month remaining until expiration.