Selling covered calls is a great way to generate income on stocks that you already own. It’s also a great way to lower the cost basis on those stocks. Selling a call options means that you as the seller of the option, are obligated to sell the underlying stock at a specific price of your choosing and at a specific future expiration date. For that obligation, you are collecting a premium from the person who wants to buy your stock at the strike price.
How Covered Calls Work
Here is an explanation I heard a while ago that might help you understand how a covered call works, and who is paying you the premium: Since I am selling a covered call, I own the stock. Let’s say I am a landowner, and a real estate developer likes my land and wants to buy it. Let’s say its worth about $1,000,000. However, they don’t want to fork over a million dollars without knowing if or what they can build on that land. They need to find out if they can build condos, a shopping center, or maybe offices. Once they find that out, they also have to get permits to build. As you can imagine, this takes a lot of time, so while the developer is doing all of this, anyone else can come in and buy my property. So, the developer will offer me some money upfront; say $50,000, for the right to sell my land to him at a specific price ($1,000,000) anytime between now and a future date.
Now the developer doesn’t have to worry about anyone else coming in and buying that property, and it allows that developer to get all of the research done to see what can be built on that property as well as getting the permits needed to build on that land. If the developer is unable to do anything with that land, then all he or she lost is the $50,000 that they gave me to hold onto the property for them. If they do decide to move forward, then they pay me $1,000,000 for my land and now it is theirs, because I agreed to sell my land at a specific price and by a certain time. For that obligation, I was given $50,000. That is mine to keep whether the land developer buys my property or not.
Back to our Covered Call Example
I own shares of XYZ and its currently trading for $55. I want to generate some income from this stock, or I may want to just sell it. If I could sell it for $60, I would be happy. I am going to sell a call option at a strike price of $60 and I want the expiration to be 3 months from now. The premium I am collecting is coming from someone who wants to buy my stock at $60 because they may think the stock could be above $60 in 3 months from now. The premium I am collecting depends on a few factors such as length of expiration, volatility of the stock, and the stock price. Longer expirations pay a higher premium than shorter expirations, volatile stocks pay a higher premium than low volatility stocks, and higher priced stocks pay a higher premium than lower priced stocks.
Let’s say we collect $2 in premium. A few things could happen. If, at expiration, the stock closes at $60 or higher, then I have to sell my stock. That’s not a bad outcome because I decided I wanted to sell it at $60. And since I got paid $2 for the obligation of selling, I lowered my cost basis by $2. If the purchase price was $55 and we sold it for $60, our ROR is 9%, however, the $2 reduction in cost basis means that our cost basis is $53 and with a sell price of $60 our ROR is 13%. That’s quite a difference in return! Now, if the stock does not get to $60, then I get to keep my stock, I keep the $2 premium, and I can do it all over again! I will sell another covered call for 3 more months (or any timeframe you choose), and continue to collect premiums that will drive down my cost basis and increase our returns.