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Benefits of a covered call option strategy

Montréal Exchange
October 28, 2022
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Benefits of a covered call option strategy



Covered call options refers to holding a stock as part of your portfolio while simultaneously selling a call option on the same stock. Owning the stock outright is quite simple but deciding which option chain to sell can be a challenge.

There is no one-size-fits all approach to selling call options. Some of the variables to consider include: 1) a strike price that best aligns with your view of the underlying stock, 2) what price are you willing to sell your stock position, 3) what option expiration date to use as annualized gains are the highest when selecting call options that expire the earliest.

That said, here are some general rules that apply to both bullish and bearish investors:

  • Attempting to profit from an unreasonable strike price is less likely to result in a favorable outcome.
  • Investors can use covered call writing as a core portfolio strategy which implies the cash flow generation from the sale is more important than owning the stock outright.
  • Investors should typically avoid writing call options on fast-growing companies as owning the shares for long-term gains is likely to result in superior gains.
  • If an investor is wrong about the stock’s potential, an out-of-the-money call offers minimal downside protection.

Tips for bullish investors

  • If an investor is positive about the underlying stock, they should consider writing further out-of-the-money options when selecting the strike price.
  • If an investor is bullish and expects the stock to move notably higher, they should avoid writing covered calls for maximum price appreciation potential.
  • Investors should write covered calls only when they are neutral to mildly bullish on the stock.
  • Conservative investors should focus on writing slightly out-of-the-money calls with shorter expirations.

Tips for bearish investors

  • For the most part, covered call strategies work best when the market is flat or moving slightly higher.
  • However, bearish investors that expect downside movement can still take advantage of covered call options as the call premiums can offset any losses to a certain extent.
  • Consider writing in-the-money calls. The logic here is that call options with a strike price below the current stock price increases the premium collected that will offer greater downside protection compared to at-the-money or out-of-the-money options.
  • Bearish investors may want to forego on entering a covered call play when a stock is trading below the 50-day moving average.

Conclusion

Covered call options is an ideal strategy for beginner and novice investors. By default, the strategy is less risky compared to uncovered (naked) option writing strategies, such as naked selling of call options. In this case, the investor exposes themself to unlimited losses because a stock’s price can in theory rise forever.

Regardless of the risk level of covered call writing, the overall risk profile depends on each investor’s individual comfort level. As is always the case, investors should never invest with money they can’t afford to lose.

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