selling covered calls for monthly income

8 Best Ways: Selling Covered Calls to Generate Income TODAY

Are you thinking of selling covered calls to generate income? If so, you came to the right place. Of course, if you landed here by accident, this article is sure to surprise you.

Experts agree that selling covered calls on quality stocks, and ETF’s (which I will now refer to as equity/equities) I already own is one of the safest ways to generate monthly income as the money I get from selling a covered call is guaranteed.  

In case you have read my book, you’ll know I retired as a millionaire at age 35, following many, many mistakes. While most of my money gets managed for me, I like to keep a little on the side for my trading pleasure. Indeed, one of my favorite trades is selling covered calls to generate monthly income (option premium).

What is an Option?

Before getting into selling covered calls, it’s important to know what an option is. An option is simply a contract between two people, a buyer, and a seller. The option seller (also known as the option writer) sells an option to the buyer. The option gives the seller the obligation to do something should the buyer request it. Simple!

What is a Call Option?

You may have heard about selling puts, or put options – that’s actually another article. For the purpose of this article, we’ll be talking about call options.

First, it’s essential to know what a call option is. A call option is a contract where the buyer has a right (but not an obligation) to purchase an item (in this case, shares) at a set price. The seller has an obligation to sell the item if the buyer requests it (called exercising). 

What Is a Covered Call?

The “Covered” portion of the covered call simply means that the call seller already owns the equity that he or she is selling the call option on.

How a Selling Covered Calls Works

For example, let’s take Jimmy, Sally, and a pound of beans.

Today, beans are worth $10 a pound.

Jimmy has a pound of beans and wants to sell someone an option to purchase his pound of beans, in one month, for $10. You see, Jimmy thinks the price of beans will be about the same or lower (next month) than they are today.  

On the other hand, Sally thinks the price of a pound of beans will likely go up next month. So, Sally enters into an agreement with Jimmy to buy his pound of beans in 1 month. In return, Sally pays Jimmy a fee for this contract (this is the covered call). Sally and Jimmy negotiate a fee of $1 for this option. The $1 is the income (option premium) that Jimmy gets to keep, no matter how much the beans go up or down in value.

Jimmy collects the $1, and agrees to sell Sally his pound of beans next month for $10.

One month goes by…

selling covered calls calendar

Fast forward next month, if a pound beans cost more than $10, Sally will buy the beans from Jimmy for $10. Otherwise, if the beans cost less than $10, her option contract is worthless. Whatever happens, Jimmy gets to keep his income (option premium) from Sally.  

Who would you rather be? Jimmy, or Sally?

All options have rights and obligations. For example, those who buy call options have the right to buy the underlying equity from the seller at any point before the expiration date. In exchange, the option buyer pays the seller an option premium (income). And, this premium is guaranteed income that you get to keep. Best yet, you can repeat the trade, again and again, week after week, month after month.  

Things to Know About Selling Covered Calls

Like any investment, you’ll need to know some basic things about it. To be sure, selling covered calls requires a certain amount of understanding of the rights and obligations for both parties.

What do I need to Sell a Covered Call

To sell a covered call, you first need to own the (underlying) equity. And, considering each call option contract is for 100 shares of the underlying equity, you’ll need 100 shares x the number of call option contracts you wish to sell.

For example, if you want to sell 1 covered call option on the SPY, you’ll need to have 100 shares of the SPY in your brokerage account. Conversely, if you want to sell 5 covered call options (and earn 5x the money), you’ll need to have 500 shares of the SPY in your brokerage account.

What if I don’t have the equities in my brokerage account?

If you want to sell a covered call on the SPY, but don’t have or want to own the SPY, this is called naked option selling, and theoretically has unlimited risk. To be sure, it’s beyond the scope of this story.

Covered Call Lingo

dictionary lingo

Strike Price

The strike price is the contracted price that the buyer can buy the equity from you (stock, or ETF). In the Jimmy and Sally example, $10 is the strike price.

Expiration Date

The expiration date is the last date the buyer can purchase the equity (called exercising) from you.

Option Premium (Your Income)

The option premium is the amount of money you get to collect for selling the covered call.

How Does a Covered Call Work?

First, for each call option you want to sell, you will need 100 shares of the underlying equity. For example, if you’re going to sell 2 call options on the SPY, you’ll need to have 200 shares of the SPY already in your brokerage account.  

Second, you will need to determine the strike price to sell the covered call option. In general, I like to sell options “At the money” or slightly “Out of the money.” An “At the money” call option means the underlying equity and call option strike price is essentially the same. By contrast, an “Out of the money” call option means the strike price is higher than the underlying equity.  

The Mechanics

mechanics of a covered call

Example of “At the Money” and “Out of the Money” Call Options

Today, the SPY is currently trading at $316.58.

A strike price “At the Money” would be $316.

Conversely, an “Out of the Money” strike price would be $317 or higher.

Last, there’s also another type called “In the Money.” Using the same SPY ETF above, an “In the Money” call option would be one that has a strike price of $315 or less. 

How much can you make selling covered calls?

In general, you can earn anywhere between 1 and 5% (or more) selling covered calls. How much you earn depends on how volatile the stock market currently is, the strike price, and the expiration date. In general, the more volatile the markets are, the higher the monthly income you’ll earn from selling covered calls. Conversely, when the markets are calmer, you’ll have to sell calls with a further expiration date.

I prefer to sell covered calls “At the Money”, with an expiration of about 3-6 weeks out. Indeed, this strategy gives me the most amount of income upfront. However, it limits the potential growth of the underlying equity. And, I’m OKAY with that! 

Can I Become A Millionaire?

Selling covered calls is a low-risk strategy for earning weekly or monthly income. Generally speaking, low-risk strategies, on their own, won’t make you a millionaire. If you’re looking to become a millionaire, you might first look at How to Become Financially Independent.

What are the Risks in Selling a Covered Call?

The only risk in selling covered calls is that you may lose out on potential profit. For example, let’s say you bought the SPY at $316.58 and sold an at the money covered call with a strike of $317. Then, at expiration, the SPY is trading at $319, you’ll have lost out on $2 of profit. But, don’t forget, you’ll already have collected $3.08 (times 100) for the call option itself! 

While getting called isn’t necessarily a bad thing, you need to know that in the end, you’ll have made a profit. Let’s look at the SPY example from above.

Examples of Selling Covered Calls

Let’s consider an example of selling covered calls to generate some income.

As of today, July 6, 2020, the SPY is trading at $316.58. The $317 call option expiring July 17, 2020, is currently being bought for $3.08.  

What does this mean? If you own 100 shares of SPY, you can sell 1 covered call option, and generate $308 in income, that’s yours to keep! Best yet, with selling covered calls, if you want more guaranteed income, you can one contract for every 100 shares of the underlying security that you already own.

Let’s examine the following scenario (#1)

Today, July 6, 2020, the SPY Trades at $316.58

You buy 100 shares of the SPY for a total outlay of $31658.00

Then, you sell 1 covered call contract, out of the money ($317 strike) that expires July 17, 2020, for $308

Right off the bat, you’ve earned $308 from the covered call. Indeed, that’s covered call income you get to keep. Moreover, it lowers your cost to buy the SPY by $308.

On July 17, 2020, if the SPY trades at $319, your contract will be exercised. Yes, you’ll be obligated to sell your shares for $317. Is this bad? Well, consider that you bought the SPY for $316.58, and you sell it for $317 and collect another $308 in income. So, you’ve lost out on some potential profit, but the income (option premium) is yours to keep!

Crunching the numbers

However, consider that the SPY is above $317 on July 17, 2020, and you sold your SPY equity for $317. In this case, you’ll have a profit of $42 ( $0.42 times 100) on the SPY, and you still keep your $308, for a total profit of $350. Indeed, that’s an annualized rate of return of nearly 40% in just two weeks! How cool is that?

Selling Covered Calls Scenario #2

Using the same SPY from scenario #1, you buy 100 shares of the SPY for a total outlay of $31658.00

Then, you sell 1 covered call contract, out of the money ($317 strike) that expires July 17, 2020, for $308

And like before, you’ve earned $308 from the covered call. Indeed, that’s the covered call income you get to keep. Also, don’t forget, it lowers your cost to buy the SPY by $308.

Then, on July 17, 2020, if the SPY trades lower, at $315. Note that this is lower than the strike price on your covered call. Also, it’s lower than what you paid for the SPY. Your call option contract expires worthless, and you get to keep your shares.

In this case, you get to keep your SPY, and the covered call expires worthless.  

Crunching the numbers

You initially bought 100 of the SPY for -$31658.00

You received $308 in call option income (AKA Premium)

The value of the SPY shares on July 17, 2020, is now $31500.00

Your annualized rate of return is now 15.463%. Considering over the past 90 years, the annualized rate of return of the S&P 500 is 9.8%. So, I think 15.463% is a winner!

But, here’s where it gets interesting. In this case, your call option expired worthless, and let’s assume that in this scenario, you kept the shares. Then, you can just sell another call option for the next month, and that income is also yours to keep. Rinse and repeat!

Is selling covered calls profitable?

Selling covered calls is a guaranteed way to earn weekly monthly income, and yes, it can be very profitable. The key is to remember to buy high-quality equities or ETF’s. My favorite equities for selling covered calls on are the SPY (SPDR S&P500 ETF), and large, quality companies such as Apple and Google. Indeed, over the long term, these are high-quality companies whose stock prices generally move upwards.

However, you should have a plan B in case your equity loses value. In the SPY scenario above, if it dropped to $310 or $300 at the time of expiration, what could you do? Well, you could write another call option. Or, buy more of the SPY to lower your average cost and write more options, or you could take the loss (never fun) and move on to something else.

Can You Lose Money Selling Covered Calls?

You will never lose money by collecting the income from selling the covered call. To be sure, the income you receive from selling covered calls is guaranteed. However, if the equity loses value (i.e., the SPY drops below the purchase price), AND you sell it at a loss, then yes, that could incur a loss. So, just like having a home budget where you track your income and expenses, it’s essential to keep track of your profit and loss on your covered call strategy. Starting today, you can watch my own P&L, after the traves have completed.

Bonus: What is a poor man’s covered call?

You may like the idea of selling covered calls, but don’t have or want to buy 100 shares of the stock or ETF. If so, consider: Poor Man’s Covered Call. And further, you might even wonder exactly what it is. A poor man’s covered call has two variations. As above, when you sell a covered call, the call option is covered by the underlying stocks and ETF’s that you already own. With a poor man’s covered call, you don’t actually need to own the stock! Rather, you’ll need to replace the stock with something else. Here’s the two variations:

Variation on a Poor Man’s Covered Call #1: The Vertical Spread

With a vertical spread, you sell a slightly out of the money call option, and then buy a further out of the money call option.

If we borrow from the same example as above, on July 6, 2020, the SPY is trading at $316.58.

The July 17, 2020 $317 call option is selling for $3.08.

The July 17, 2020 $320 call option is selling for $2.50

In this case, if you don’t own or want to own $31,658 ($316.58 * 100) of the SPY, then you could sell the July 17, 2020 $317 SPY call option for a total of $308. And, at the same time, you can buy the $320 call for $250, leaving you $52. The call option that you bought becomes the covered portion.

WARNING: There is a risk with a this scenario. The risk is if the SPY trades above $317, you’ll be excersised, and will be forced to sell 100 shares of the SPY at $317. However, your risk is limited to the difference between the option strike you sold, and the option you bought. So in this case, the risk is $320 – $317 = $3 – times 100 of course. So, you’ll want to consider selling this type of strategy further out of the money to avoid surprises.

Variation #2: The Calendar Spread

With variation #2, you can sell a poor man’s covered call by buying an in the money LEAPS option, as far out as possible. A LEAPS option is like a traditional option, only that it has a much longer expiration. At the time of this writing, LEAPS on the SPY go as far out as December 16, 2022 (Almost two and a half years).

If we borrow from the same example as above, on July 6, 2020, the SPY is trading at $316.58.

The SPY July 17, 2020 $317 call option is selling for $3.08.

The SPY December 16, 2022 $290 call option is selling for $52.49

In this example, you can buy the SPY December 16, 2022 $290 option for $5,249. And you can hold it until expiration. We are buying the $290 because the further in the money it is, the more correlated it will be to the actual market prices.

Then, you can start selling covered calls (out of the money). If you get exercised, not to worry, your LEAPS option will have gone up (near) proportionately. If the SPY goes down, again, you keep the income from selling covered calls.

Frequently Asked Question (FAQ)

Are covered calls bad?

The only thing that is bad about covered calls is that you lose any potential upside over and above the strike price. However, you do collect the income as a result.

What is a poor man’s covered call?

A poor man’s covered call is also known as a credit spread. In this case, the “poor man” either doesn’t have the funds to purchase the 100 shares of the equity, or just doesn’t want to buy the equity. In this case, the “poor man” sells his covered call and then buys one at a strike price slightly further out of the money (for less than the call he sold). The “poor man” gets to keep the difference, known as the credit. The risk is the difference between the strike prices. A credit spread (or poor man’s covered call) is a riskier transaction but requires less money upfront, and one for another article.

Should you sell covered calls?

Anyone seeking additional income from their portfolio should consider selling covered calls.

How do you sell calls for income?

At a minimum, you will need a brokerage account, with options trading (You might need to let the brokerage know you want to sell covered calls).

What happens when you sell a covered call?

As soon as you sell your covered call, the income (option premium)gets deposited into your brokerage account. Generally speaking, you can do whatever you want with it.

What about selling weekly covered calls?

You can sell weekly covered calls, however, just be aware that you will collect more income, the further into the future you sell the call.

What are the best stocks for covered calls?

In my opinion, selling covered calls on high-quality stocks and index ETFs gives you the best consistent return.

Are covered calls safe?

Most agree that of all option strategies, selling covered calls is among the safest strategies out there. Selling covered calls is a safe strategy because you already own the equity, and the monthly income (premium) you earn lowers the actual cost of ownership.

What is the Best Strategy for Selling Covered Calls To Generate Income

The aim of this website isn’t to provide investment advice; instead, it gives you the tools and knowledge to become financially independent.  

Conclusion

Selling covered calls can be an excellent way to generate monthly income. To be sure, any investment incurs a little risk, and I feel that by selling a covered call, you are reducing your overall risk. Last, if you’re looking for an even cheekier way to generate income, check out my article about selling Naked Puts!

Rick

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