Covered calls have received a lot of attention in the investing world in recent years. As investing has gone more mainstream, people continue to seek out different strategies to find success in the market. Look, let’s be honest: the stock market was a terrible place to be in 2022. If you just sat on your investments your account is probably in the red. But if you adopted an additional strategy like selling covered calls, you created another income stream to your brokerage account. So are covered calls a good strategy?
Covered calls can be a good strategy if executed properly and without greed. Selling covered calls likely will not make you rich, but it can help you add some extra cash into your account every month. As long as you treat it as a supplemental strategy rather than an all-in trade, selling covered calls can be a great way to earn extra income on your existing long-term investments.
Here at SavvyCanadianFinance, we believe in generating as much active and passive income as possible. Selling covered calls is one option strategy that is typically considered to be of lower risk. In this article, we will cover what exactly a covered call is and why you might want to consider using them in your investment account.
What is a Covered Call?
A covered call is a strategy that allows you to sell call options on stock positions you already own in your portfolio. Why sell call options? This can generate income for you while also allowing you to hold those stocks for the long term.
The term covered call refers to being ‘covered’ if your shares are assigned. With a covered call, you are betting that the underlying stock’s price will not rise above the strike price of the option. If it does, the buyer of the call options could exercise the option and you would be forced to sell your shares at the strike price.
The idea is that even if you are forced to sell those shares, it will be at a price you choose. If those shares are assigned, you receive the cash in your account from the buyer of the shares. You can then repurchase those shares if you want to continue holding the stock.
How Many Shares of a Stock do I Need to Sell Covered Calls?
Typically with covered calls, you will want to own at least 100 shares of the underlying stock. When it comes to options, one contact is equal to 100 shares.
For it to be a true covered call, you would sell one call option contract for every 100 shares you own. The more contracts you sell, the more premium you will earn.
Some will say that this limits the upside of this strategy. While this might be true, if you sold naked calls or calls without owning the underlying shares, you could be on the hook for 100 shares of the stock if it gets assigned.
How Far Out Should I Sell a Covered Call?
The covered call strategy has bred many different rules sets from investors over the years. Remember that this decision will ultimately depend on your investment goals and risk tolerance.
In general, the further out you sell your call option, the more premium you will earn. The trade-off is that the stock also has more time to rise above the strike price. This leads to a higher probability that your shares will get assigned.
On the other hand, selling a call option with a shorter expiration date will lead to a much lower premium. The trade-off here is that there is a much lower chance that the stock price will climb above the strike price.
There is no right answer when it comes to selling covered calls. The happy medium seems to be an expiration date that is about 30-45 days from when you sell the contract. Remember to do your own research and find a strategy that works for you.
Can You Lose Money on Covered Calls?
Yes, of course! No investment strategy is a 100% guarantee. When selling covered calls, you do limit the potential upside of the underlying stock.
If the price of the stock rises above the strike price, your shares will get assigned. This limits the upside gains you can make during the stock’s move higher. Even though you do make the income from the premium, it might not be enough to offset the missed gains.
This is basically a conversation about the opportunity cost of selling covered calls. If you need income, then selling call options is a relatively safe way to generate it. But if you think you can earn more capital gains by actively trading those shares, then you might think covered calls are a waste of time.
How are Covered Calls Taxed in Canada?
As with most investments in Canada, covered calls will be considered capital gains or income. What are the differences here? Let’s take a closer look!
When you sell a call option and it is not exercised, the premium received from selling the call is a capital gain. This means it will be taxed at the capital gains tax rate, which is lower than the income tax rate.
But if the call option is exercised, it will be considered a capital gain or capital loss. Remember to always keep track of your trades because once you start selling covered calls it can have a direct impact on your income tax.
What do I do if my Covered Calls are In the Money?
If before the expiration date, you find your options contracts are in the money, then there are a few things you can do.
To be clear, this would mean that the price of the stock has surpassed the strike price of the covered call. This means that the buyer of the contract can exercise it and buy your shares from you.
There are a few different things you can do in this situation:
- Sell the Shares to the Buyer of the Contract. If you are comfortable with selling your shares at the strike price, you can simply wait for the option to be exercised and then receive the proceeds from the sale.
- Buy back the Call Option you previously sold: You can buy back the call option to close out your position. This will allow you to keep your shares and avoid having them assigned. Just be mindful that buying back the call option will result in a loss on the option.
- Roll the Call Option: You can sell the call option with a later expiration date at a higher strike price. This allows you to potentially earn more premiums and avoid having your shares sold at the current strike price.
- Do Nothing and Wait: If you are comfortable with the idea of having your shares sold at the strike price, you can simply wait for the shares to be assigned.
Are Covered Calls Better Than Cash-Secured Puts?
When comparing investment strategies, it is always important to take in your personal situation. Always consider your risk tolerance, investing horizon, and long-term goals.
Selling covered calls involves holding the shares of the stock in your portfolio. When you sell cash-secured puts, you need the money in your account in case your contract gets assigned.
When selling cash-secured puts, you will need to set the cash aside to purchase the shares if required. Like with covered calls, selling puts provides you with income in the form of premiums. If the stock falls below the strike price, you could be on the hook for buying those shares. This is why it is important to have the cash on hand to secure your puts.
The Bottom Line: Are Covered Calls a Good Strategy?
Trading options contracts can be risky at the best of times. Strategies like selling covered calls or cash-secured puts bake in a higher floor. This is because both strategies have collateral on hand in case the trade goes against them.
Selling both types of options contracts is a great way to create an additional income stream for your account. Most brokerages require you to apply and gain approval to trade options. Once you do, you could be investing in a cash-generating machine. As always, do your own research into covered calls and make sure they fit your investment strategy.
Stay savvy!