What is a Covered Call?
A covered call is the most popular strategy for generating income using options. There are two separate steps required to execute this strategy – purchasing a minimum of 100 shares of a security and writing (selling) an “out of the money” call option. This income strategy is most effective when there is a neutral or bearish sentiment on a stock. As the seller of the option contract, you receive immediate income in the form of the premium paid by the buyer of the call option.
What’s the best strike price for a covered call?
An investor selling a covered call should look to an out of the money (OTM) strike price. In the case of selling a call, an OTM strike price would be higher than the current market price of the stock. For example, if $XYZ was trading at $100, sell a call option with a strike price higher than $100. The further OTM the call option is, the less premium you would collect, as there is a lower probability of the stock price reaching the strike price by the expiration date. Picking a strike price that is close to the current market price of the stock may be tempting as there is a higher income, but there is also a higher probability of the stock reaching the strike price during the life of the contract.
Read our post on Expiration and Strike Selection to learn more.
Why use a Covered Call instead of a Sell Limit Order?
Consider the following example:
Position: Investor owns 100 shares of $XYZ @ $100
Covered Call: Sell Oct 15, 2021, $120 Call @ $2.00 (per share)
|Enter Sell Limit @ $120||Sell Oct $120 Call @$2|
|Risk||$100/share||$98/share ($100-$2) (premium of covered call)|
|Reward||$20/share ($120-$100)||$22/share ($120-$98)|
|Profitable||Above $100||Above $98 ($100-$2)|
|Time||Exposure until $XYZ rises to $120||Rinse and repeat as income strategy until $XYZ rises to $120|
Using the example above, selling an Oct 2021 $120 call @ $2 generates an immediate income of $2 per share ($200 in total). Assuming the investor bought the shares at $100, the Covered Call strategy would be profitable if the market price of the stock remained above $98 ($100 – $2 premium), whereas the sell limit strategy would only be profitable if the stock remains above 100. This reduces the overall risk of the stock holding once an investor starts to sell covered calls against it.
Best Practices for Covered Calls
Selling short-term options (3-7 weeks) tends to provide better results. Short-dated options have an advantage over longer-dated options due to earnings cycles. Longer-dated options can be exposed to more earnings releases during the option contract, subject to larger price fluctuations.
As mentioned earlier, an investor using a Covered Call strategy would find it beneficial to use an OTM strike price as there is a lower probability of the stock reaching that price. However, OTM strike prices and premiums received have an inverse relationship. The selection of a suitable strike price can be optimized by using Delta, as it represents an approximation of the probability that the stock will be above the strike price at expiration. Generally, our backtesting shows that the best performance is achieved with Covered Calls using lower delta strike prices (15-20 delta).
The goal of the strategy is to select a strike price that is typically far away from the current price. This is so that if the stock was to rally sharply, you can participate and potentially take profit on the stock if it is above the strike price. With a 10 Delta Covered call, that translates to 1 out 10 times the stock will rally above the strike price and take profits, or 9 out of 10 covered calls will expire worthlessly and result in keeping the income.
OptionsPlay’s Optimal Covered Call Report helps investors find optimal covered calls for their portfolio. This report gives you all the information you need to use Covered Calls and includes important metrics such as IV Rank, Liquidity Rank, Annualized Returns, and more! The Trade Link feature allows investors to open the Covered Call trade on their OptionsPlay platform at the click of a button. The report is also updated twice daily.
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