Introduction to the Covered Call Strategy

Background

In this article we established that investing in the stock market is a good idea.

In this article we learn how to invest in the stock market, and that using options can increase your returns.

In this article we learn how options work, and that the covered call strategy is based on an option’s time decay.

Time decay

The covered call strategy profits from an option’s time decay. How? Because with a covered call, you’re selling the option first, allowing time to pass (which causes the option to lose value), and then buying the option back at a lower price.

This can be confusing at first. How do you sell something before you ever own it? With regular shares of stock this is called short selling, and it works by borrowing the shares before you sell them. Then, after the price has gone down, you buy the shares back, and then return those shares to the owner.

But with options you’re not borrowing contracts; you’re really just acknowledging math. The system doesn’t care if you buy first and then sell, or sell first and then buy; the system just cares that if you sell, then you buy back to make things even. If you sell an option first, then you have negative 1 contract. As long as you buy the option back, then you bring yourself back to 0, so you’re cool.

Short selling is notoriously risky because the thing you short can theoretically increase in value to infinity – which means that you as the short seller are at negative infinity.

Due to the inherent risk of short selling, brokerages do not allow inexperienced traders to simply short an option.

However, what would happen if you owned 100 shares of a stock, and then shorted an option for those shares? You’ve just cancelled out the intrinsic risk of shorting. Because for every dollar that your option loses value due an increase in the underlying stock’s price, your stock gains a dollar. Hence, you have a covered call – a short call that is “covered” by owning the underlying stock. (The process of cancelling an option’s losses due to underlying stock price movement doesn’t apply to an option’s time value – time only ticks one way, so short options can only gain value over time – no need to “cover” time with stock.)

The covered call strategy

A covered call consists of owning 100 shares of stock (or ETF), and selling a call option for that stock (or ETF).

To start the covered call strategy, you first buy 100 shares of stock. Then, you acknowledge the fact that options lose value over time (all other things being equal). So you sell a call option for your stock. As time passes, the person who bought your option loses opportunity to make money on the option, so the option loses value. Then, as the option’s expiration date approaches, you buy the option back at a lower price (bringing your position from -1 back to 0).

The covered call option is best suited for stock that you want to hold for the long run.

The reason a covered call is ideal for a long-term strategy is that if the underlying stock price falls, you could be tempted to sell your shares – which would prevent you from selling your call options. So, in the covered call strategy, you need to be able to hold stock long-term in order to make profit from option time decay. That’s why it’s important to apply the covered call strategy to stock that you trust will regain value, even after a temporary price dip – hence, my recommendation to apply this strategy to the S&P 500.

There is one more important point to make when discussing short calls. Because call options lose money when the price of the underlying stock decreases, a short call helps hedge market declines. No, it doesn’t remove all risk from a price decrease – a call’s value can only go to zero, which means the upside of a short is limited. But it does help hedge the downturns. And, if you sell your calls for more than you lose in market downturns, it’s possible to return a profit even in down markets.

Read the next article to learn, more specifically, how to implement the covered call strategy.