Writing covered calls for income is getting a lot of attention lately. Investors are tired of the low yields they see with Treasuries and the risks they have to take with junk bonds. Although investing for income and trading options can appear to fall on two very different sides of the risk-tolerance spectrum, some investors are bridging the gap and making it work.

In this article, we’ll examine why investors are making this move, the benefits and risks involved, and how to make covered call writing part of your portfolio strategy.

How Covered Calls Work

One strategy uses covered calls “against” individual stocks. Let’s unpack that a bit.

A covered call is when an investor sells a call option and owns an equivalent amount of the underlying stock. So the investor who had been holding a long position in that stock, then writes a call option on that same stock to generate an income stream.

The covered call strategy works best when an investor thinks that the stock they own won’t see much price movement. So, they’re predicting that in the short term, the stock price will remain relatively steady and won’t experience any sharp upticks or downticks. 

So the investor holding this stock writes (or sells) a call option contract at a stock price higher than the current market value. The buyer pays the seller an option premium, which generates the option income for the stockholder. 

Remember when you write a call option, you’re selling the right, not the obligation, to sell a stock at a specific price (the strike price) during a certain time period, which ends with the option expiration date. 

Essentially, what you’re doing here is insuring against upward movement in the stock price, but betting that the stock price will stay put.

The call premium is what generates income and gives you some additional income on a stock whose price isn’t moving to generate income for you that way. Plus, if the current price dips, you’re essentially losing less because the premium payment you receive will offset some of that downturn in the stock price.

A Covered Call Example

Let’s say Company XYZ is trading for $65 per share, and you own 100 shares. 

You have a hunch that the stock price is going to hover there or even dip in the near future. So, you sell a call option, which allows some other investor to buy your shares of the underlying security at $70 each (strike price) any time during the next three months. 

In exchange for this right, that other investor pays you a premium. This is how you’re going to generate income.

Benefits of Writing Covered Calls for Income

You’ll generate income that is almost entirely passive if one of the following two events occur.

First, if the stock price dips lower than the price at the time you wrote the contract, the option expires worthless, meaning that the other investor won’t come calling to exercise it. So you keep the premium and you keep your stock position. Plus, now your loss is less than it otherwise would have been.

Second, if the stock price rises but stays below the strike price, the option still expires worthless. The stock is now worth more, and — best of all — you keep the premium too. There is your income for selling the option and letting the stock price do the work for you.

Is Writing Covered Calls for Income Risk-Free?

It’s true that covered calls are a risk-free income strategy in the sense that once you write the options contract, the premium you receive is yours. You keep it, regardless of what happens next. 

But of course, writing covered calls is not entirely risk-free. 

The covered call will provide extra income for buy-and-hold trading strategies. But as with any trade, you’re facing the downside risk of lost opportunity. 

The Risk of Lost Opportunity

Remember that investor who bought the call option from you? That option buyer on the other side of the trade has the right (but not the obligation) to buy the stock. If your initial prediction was wrong and the price spikes, that person is likely to take you up on your offer and exercise their right to buy the shares from you at the strike price that is under the current market value. And guess what? You have to honor that offer and sell them your shares.

If the stock’s price rises significantly higher than the strike price of your call option, your shares will be called away below stock market value. So, you lose out on all of that upside potential. For some investors, this is just not acceptable. For others, the risk is worth it considering the extra income they can potentially generate.

Let’s go back to our example to feel the pain of this risk. 

Imagine that XYZ has a product you thought was about to tank, but your information was bad. The product ends up becoming revolutionary, and the stock price jumps to $85 per share 10 days after you wrote the covered call. You now have to sell the stock to that other investor for $70 per share. The option buyer now gets to enjoy the capital gains that could have been yours.

Not only that, but if you didn’t cover your call, you’re going to be out $1,500 (($85-$70) x 100), which is likely more than you received for the premium. And if you did cover the call, now you’re going to have to sell the stock.

Essentially, covered calls can be an effective income strategy, but let’s be clear, they’re not a sure thing. You’re exchanging upside potential in return for the opportunity to generate income. 

Some investors who trust their instincts and have a lot of experience see this strategy as a slam dunk. But for other investors who are still feeling out the market, it’s important to understand what happens if something really positive happens and your stock jumps higher.

Being forced to sell stock below market price is more than just a lost opportunity. It can also be a straight-out loss, if you’re selling the stock for less than you bought it for — especially if the difference isn’t made up for by the premium.

How to Mitigate the Risks

Although you can never really eliminate risk when investing, here are a few ways to minimize your risk:

• Never write a call option unless you own the underlying stock. 
• Only sell covered calls for stocks you own and are hoping to keep. 
• Set your strike price above the current market price of the stock. 
• If the stock is a dividend stock, only sell a covered call option after you receive your dividend payout. 

How Beginners Can Get Started Writing Covered Calls for Income

If you think writing covered calls is right for your investment portfolio, don’t be intimidated by what you see as the complexity of options trading. Taking steps to mitigate risk is a critical part of retirement planning and any investment strategy. Writing covered calls for income does exactly that. And making a commitment to learn about new investment strategies can be the difference maker for a really secure retirement.

One way to ease-in to writing covered calls is with mutual funds or exchange-traded funds (ETFs) that include covered calls as part of the portfolio strategy.

Another way is to keep making progress toward becoming a thoroughly educated investor.

Becoming a Truly Educated Investor

Now you understand why investors are finding covered calls to be an attractive income-generating strategy. You’ve taken the first important step toward understanding the benefits and risks, and how to make covered call writing part of your portfolio strategy. 

It’s time to keep learning. Subscribe to Investors Alley’s “Options Floor Trader PRO” newsletter to find out how to turn your extra cash into a worthwhile investment.