The Covered Call Strategy (In Depth)

Near the top left of the screenshot, you can see a tiny number, 47.00, in green. 47.00 is the cost, in dollars, of one share of SPLG at the time the screenshot was captured. (The “Stock Price”, or ETF price, is also shown in a green row in the middle of the chain.)

On the left you can see a column of strikes ($43-$51). Between the column heading (Strike) and the first strike ($43) you can see a date of 17 Feb 23, and “31D,” which indicates that February 17 was 31 days away at the time.

The option stats at the top of the chain are highlighted blue – in Webull (my preferred brokerage), this indicates that those strikes are in the money. That means that the option holds intrinsic value.

What is intrinsic value? It is the difference between the strike price (of in-the-money options) and the underlying stock price at expiration. So if you have a $46 strike option, and the underlying stock is $47 at the time that your option expires, you have the right to buy 100 shares at $46 per share, and you could then turn around and sell those shares at the current market value of $47 per share, netting you $100. In this case your option would have $100 of intrinsic value.

The options at the bottom of the screenshot are not highlighted, which indicates that they are out of the money. This means that, by the time these options expire, they’ll be worthless if the stock price remains the same. So if you had a $48 strike option that expired when the underlying stock was at $47, then your option would be worthless, because nobody would buy the right to buy 100 shares of stock at $48 through an option when they could buy the shares outright for less ($47, in this example).

The entire value of out-of-the-money options, then, is time value. In other words, the only reason these options have value is because of their potential to become profitable. And they continue losing money as time passes, until they hit $0 at expiration.

It is the out-of-the-money options that we generally want to sell when using the covered call strategy.

The numbers shown in the Bid and Ask columns of the screenshot show the bid and ask prices of the options, but the Mid price is more relevant since you can often trade at the middle price. But you may notice that, for the $48 strike option, for instance, the price is shown as 0.58. That is because option chains show the price that the option would be for a single share of the stock. But, since options control 100 shares of stock, you need to multiply the given price by 100 to determine your trade price. So if an option chain shows a price of 0.58, the actual trade price would be $58.

Let’s walk through an example of how one might utilize the call portion of the covered call strategy.

The first step is to choose the expiration date of your option. SPLG options currently expire the third Friday of every month. The time value of an option decreases faster the closer you are to expiration. Therefore, it is typically good to choose the nearest dated expiration date when selling your first call. However, if there is less than a week left before the nearest dated option expires, it would probably be easier just to sell the next month’s option.

Next you’ll need to choose a strike price. You already know that it’s expedient to sell out-of-the-money options (unhighlighted in the option chain), but which one should you sell? The closer an option is to the stock’s current price, the more valuable it will be. However, the closer an option is to the stock’s current price, the higher the chance that the option will start losing you money if the underlying stock rises too much.

Given our knowledge that the stock market gains an average of 14% per year (before inflation), which translates to about 1.2% per month, a good approach is to sell the option that is about 1.2% out of the money. This would allow you to make the maximum profit from the option portion of our strategy, without negating the average gain of the market. At the current price of $47, a 1.2% buffer is about $0.56. I would recommend that you choose a strike that is a minimum of $0.56 out of the money.

Using this $0.56 minimum, we see that the $48 strike is the lowest (and, therefore, most valuable) strike we can sell. Sell the option and you will receive a $58 premium (the trade price of the option).

As time passes, the option loses time value and gains you money. The week of your option’s expiration (Monday, for example, with four days to expiration) you can close the position. To close your short call, you simply buy back the option.

Then you would repeat the process by selling another call for the following month, using the same principles as outlined above. This can be a relatively passive strategy if you set a calendar reminder for the Monday before the third Friday of the month. On this day every month you would simply buy back your current option and sell next month’s option.

However, there is some flexibility. If the market is coming off a strongly bullish month, you can consider selling a strike that is closer to the current SPLG price (less than 1.2% out of the money), since there’s a stronger chance that the market won’t perform as well the following month. Conversely, if the market is coming off a strongly bearish month, you can consider selling a call further out of the money, since the market could rebound. But if you prefer the more passive approach, simply sticking to our minimum of 1.2% out-of-the-money rule works for the average market performance over the last 10 years.

Potential performance

While it’s impossible to predict exactly how much this strategy can make, it is possible to estimate.

At the same time that I screenshotted the 31 days to expiration option chain, I screenshotted the 3 days to expiration chain. The combination represents how much you could sell next month’s option for and how much you could buy back this month’s option for. In other words, it would approximate your monthly income from selling covered calls.

As you can see in the 3 days to expiration screenshot, you could buy the $48 strike option for just $5. This equates to an income of $53 per month, or $636 per year. Given the $4,700 SPLG investment (the cost to buy 100 shares of SPLG in order to implement the covered call strategy), this translates to a 14% return on investment per year – which, coincidentally, is the same as the pre-inflation-adjusted average market performance over the last 10 years (also 14% per year). So, combining your 14% SPLG average return on investment with your 14% call selling, you are at 28% per year.

It’s important to note that this is just an estimation. There are a lot of variables, which could affect the return on investment, up or down. Selling options closer to the underlying stock price would yield higher premiums, while selling options further from the stock price would yield a lower premium. If the market moves higher during the month then you probably wouldn’t make quite as much selling calls, while if the market moved lower then you would likely make more selling calls.

A few things to know

While unlikely, it’s worth noting that your short option could be exercised before or during expiration. Remember, if you own a call option then you own the right to buy shares at or before expiration. So if someone exercises the option, that means they’re choosing to buy your 100 shares at the strike price. So your 100 shares would be sold to them – leaving you with cash, but no shares. Now, it isn’t prudent for the person who bought your call to exercise it early since they would miss out on selling whatever extrinsic value is left to the option. Simultaneously, it would likely be beneficial to you since you would not need to buy the option back – it’s like fast forwarding time to get 100% of the time value that was left in an instant. Hopefully you could simply re-buy 100 shares and come out on top. The only issue would be if the underlying stock price were to jump up before you could buy. This isn’t typically a problem for index -tracking ETFs like SPLG, but it is someone to keep in mind.

As we said before, options can be exercised at expiration. In fact, for American style options, which SPLG options are, any time an option expires in the money by one penny, it will automatically be exercised. That means that, for our example, if SPLG were to rise to $48.01 by 4:00 p.m. EST on the expiration day, your 100 shares of SPLG would be sold at $48.00 each. You would then need to repurchase shares to continue the strategy. However, we do not hold our options to expiration, so this won’t be an issue unless you forget to manage the option.

SPLG issues dividends. For our purposes, a dividend is a per-share cash amount issued to shareholders once per quarter. This amount will vary from quarter to quarter, but the current dividend yield is $0.96/year/share. For 100 shares, that equates to $96/year – this is enough to buy two more shares of SPLG per year at the current price.

Conclusion

The covered call strategy with SPLG is, essentially, a way to earn income on an S&P 500 investment. An S&P 500 investment is a good idea since is gains 14% per year on average. Selling covered calls on that investment increases those returns.

Want a $45 signup bonus for using my preferred brokerage, Webull? Go here.

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