Covered Calls – A Recap
Covered calls are a strategy that combines owning a stock (long stock) with selling a call option on that same stock. The option grants the buyer the right, but not the obligation, to purchase the stock from you at a certain price (strike price) by a certain time (expiration date). You collect a premium for selling this option contract.
- Selling Calls on Stocks You Want to Hold: Covered calls generate income, but if the stock price rises above the strike price and your call gets exercised, you’ll be forced to sell your shares at the strike price, even if it’s lower than the current market price. This limits your potential upside.
- Ignoring Underlying Stock Volatility: If the stock price becomes very volatile, the option premium can become much higher. This can be tempting, but increased volatility also means the stock price could rise above your strike price more easily, leading to early assignment.
- Setting Strike Prices Too Low: A lower strike price increases the premium you receive, but it also increases the chance of early assignment. Choose a strike price that aligns with your profit target and risk tolerance.
- Not Considering Time Decay (Theta): Theta is the time value of an option, which gradually decays as expiration approaches. This means you’ll generally earn less premium the closer you get to expiration. Factor in theta when choosing your expiration date.
- Not Managing Your Position: Monitor your covered call position throughout its life. You may want to buy back your call option early if the stock price soars and you want to capture more upside potential, or if the premium drops significantly.
Remember: Covered calls are a conservative strategy for income generation, but they come with limitations. Be sure to understand the risks involved before using them.