A Step-By-Step Guide to Selling Covered Calls (For Income)

If you’re thinking about generating additional income while holding on to your stocks for the long term, then selling Covered Calls is the option strategy that you want to master.

By selling Covered Calls, you can get at least an additional annualized return on investment of 5 to 10 percent.

And the best part is that it helps with reducing the cost basis of your stock.

However, you don’t want to just sell Covered Call strike prices that give the highest premium.

That’s because if the stock rallies and your Covered Call is in-the-money at expiration, then your Covered Call will get assigned.

And that means that your stock will get called away.

So if your intention is to hold on to the stock for a long time…

Then you want to choose the strike prices that have little chance of getting assigned, and also give a decent premium.

So knowing when to sell Covered Calls and at what strike price to sell is very important.

What is a Covered Call?

A Covered Call is selling a Call option against either 100 shares of stock or a LEAPS Call option.

If you sold a Call option against a LEAPS Call option, that’s what we call a Poor Man’s Covered Call.

And it’s called a Poor Man’s Covered Call because you put up less capital compared to if you were to buy 100 shares of stock.

For the purpose of this post, we will only be talking about selling a Covered Call against 100 shares of stock.

Now, by selling a Covered Call, you are essentially selling the “Right to buy the underlying stock at the strike price before the expiration date.”

So as the seller, you have the OBLIGATION to sell 100 shares of the underlying stock if the buyer of the Covered Call decides to exercise the option anytime before the expiration date.

And if your Covered Call is in-the-money at expiration, then your broker will automatically exercise the option. resulting in your share being called away.

So it’s important to ensure that you have at least 100 shares of stock to sell the Covered Call against.

That’s because if you sell a Call option without 100 shares of stock, it’s considered a Naked Call.

And if your Call option is assigned, you will now be Short 100 stocks.

So for Naked Calls, the loss can be unlimited because there’s no limit to how high a stock can go.

I know of many people who lost their life savings because of a single Naked Call.

You definitely do not want to be one of them!

So let’s take a look at a Covered Call example.

Let’s say you bought 100 shares of IBM at the current price of $137.50.

Then you immediately sold a Covered Call at the strike price of 142 with a days-to-expiration (DTE) of 30.

This means your Covered Call option will expire in 30 days.

By selling this Covered Call, you received a credit of $2.04.

And since each option controls 100 shares, the total premium you collected is $204.

This money is immediately credited into your trading account.

Now, at expiration, there are two scenarios that can happen.

Scenario 1: IBM closes above $142 at expiration day.

In this case, you are obligated to sell your IBM shares at $142.

That means even if IBM rallies all the way to $200 at expiration day, you are still obligated to sell your shares at $142.

Your profit for IBM will be:

• Capital gain from shares: ($142 – $137.50) x 100 shares = $450
• Premium collected from Covered Call: $204
• Total profit: $450 + $204 = $654
• Capital outlay: $137.50 x 100 shares = $13,750
• Annualized ROI: ($654 / $13,750) / 30 days * 360 trading days = 57.05%

Scenario 2: IBM closes below $142 at expiration day.

In this case, your Covered Call expires worthless and you keep the premium.

Then you can choose to sell another Covered Call again.

And if that expires worthless again, you can keep selling another Covered Call.

Annualized ROI on Covered Call: ($204 / $13,750) / 30 days * 360 trading days = 17.80%

Why Sell Covered Calls?

Now, you must be thinking to yourself that selling Covered Calls can be a double-edged sword.

That’s because if your Covered Call does get in-the-money at expiration and your stock gets called away…

You will lose out on all the upside gain of the stock if it continues higher.

So why sell Covered Calls at all?

Well, there are three reasons why you want to sell Covered Calls.

Reason #1: Consistent Income

The first reason is that by selling Covered Calls, you can get a consistent income.

For example, if the stock keeps going sideways for an extended period of time, you can keep selling Covered Calls every 30 – 60 days.

And even if the stock goes up a little but doesn’t go above your Covered Call strike price, then you can keep selling Covered Calls at higher and higher strike prices.

You see, thinking that you will lose out on the upside move of a stock is just a one-sided thought.

What if the stock crashes?

If you didn’t sell a Covered Call, you would have lost out on collecting premiums that can help you offset the purchase of your stock.

And this leads to the next reason…

Reason #2: Cost Basis Reduction

By collecting premiums from selling Covered Calls, you get to reduce the cost price of your stock.

In the Covered Call example that I shared with you above on IBM, the cost price for buying 100 shares of IBM is $13,750.

By selling the Covered Call, you received a premium of $204.

This lowered the cost price of your stock:

• Without Covered Call: $13,750
• With Covered Call: $13,750 – $204 = $13,546

With a lower cost basis, it means your breakeven price is now lower.

And if you keep selling Covered Calls, it can drastically reduce your cost price and breakeven price.

If you do this long enough…

You can even get to the point where the premiums you received from your Covered Calls is enough to offset the purchase of the stock!

That means you got the stock for free!

That’s why if done right, selling Covered Calls can greatly reduce your cost basis and in turn increase your profitability.

Reason #3: Get Paid While Waiting For Your Stock To Hit Your Profit Target

Finally, selling Covered Calls is a way for you to get paid while waiting for your stock to reach the profit target you’ve set for your stock.

If you’re trading, you would normally place a Sell Limit Order to take profit on your stock position.

So instead of placing a Sell Limit Order, you can replace it with a Covered Call.

For example, if you bought a stock at $100 and you want to take profit at $110, you can keep selling a Covered Call at $110 until the stock finally goes above $110.

And since you already planned to get out at $110, your capital gain would be capped at $10 per share.

By selling Covered Calls, your profit would be $10 per share PLUS all the premiums you collected until your Covered Call got assigned.

That’s why selling Covered Calls at your profit target is better than just placing a Sell Limit Order.

Long Stock VS. Covered Call Position

The graph above shows the Profit & Loss graph of being Long 100 shares of IBM at $137.52.

If the stock goes up $1, you make $1.

If the stock goes down $1, you lose $1.

Very simple and straightforward.

Now let’s take a look at the Profit & Loss graph of a Covered Call.

From this graph, you can see that you have sold a Covered Call at the strike price of 142 for a premium of $2.04.

Now, I want you to really take a look at both the Long stock graph and the Covered Call graph again.

Did you notice that at the current price of $137.50, the Long stock graph shows that it’s at breakeven, whereas the Covered Call graph shows a profit?

That means that even if the stock does not move much and settles around the current price at expiration, you would still be in a profit.

But if you were just Long stock, then you would be at breakeven or a slight profit/loss.

And if the stock was to drop to around $135.50, you would be at a loss of $200 for 100 shares.

But if you had a Covered Call, you would still be $4 in profit because of the $204 premium you had collected.

On the flip side, if the stock was to rally past $142, your profit would be capped with a Covered Call position.

And if you see on the Covered Call graph, the max profit you make on the position is $652.

But then again, if you had sold the Covered Call at the 142 strike price, it means that’s the price at which you’re willing to let go of your shares.

If you’re not willing to let go of your stocks at $142, then you could roll your Covered Call to a further dated expiration at a higher strike price.

Or, you could simply not sell the strike price at 142 and sell a higher strike price.

And if the higher strike price doesn’t give you a decent premium, then all you have to do is wait till the stock goes higher before selling a Covered Call.

5 Steps to Selling A Covered Call

Are you excited to get started selling a Covered Call?

Great!

Here are the 5 steps to take to sell a Covered Call.

Step 1: Ensure you have 100 shares of stock.

This might seem like common sense.

But many people do forget that they have yet to own the stock, have already sold the stock, or only have less than 100 shares of the stock.

So do check that you have at least 100 shares of the stock before selling a Covered Call.

Step 2: Look for Call options with DTE 30 – 45.

Next, you want to look for the options with at least 30 – 45 days left to expiration.

Now, while you can certainly go for shorter DTE Covered Calls (shorter DTE options generally give a higher ROI on premium received)…

The strike price is usually not as far away from the current stock price.

Let’s compare the DTE 8 Covered Call with the DTE 43 Covered Call:

The DTE 8 Call option with 18 Delta is at the strike price of 113.

Whereas the DTE 43 Covered Call with 18 Delta is at the Strike of 120.

That’s 7 points difference, which equates to a difference of $700.

That means if either of the Covered Call was to be in-the-money at expiration…

With the DTE 43 Covered Call, you would make an additional $700 in capital gains and $60 in the premium difference from selling the Covered Call.

So while you may earn a higher ROI from selling the DTE 8 Covered Call, your overall profit would be lesser than selling the DTE 43 Covered Call.

And if you’re just starting out selling Covered Calls for the first time…

I’d suggest starting off with selling Covered Calls with DTE 30 – 45.

Only when you’re more experienced, then you can start exploring the short DTE Covered Calls.

Step 3: Identify where you would like to sell a Covered Call (Delta 15 – 25).

Next, you want to identify where you’d like to ideally sell your Covered Call.

For example, if you bought the stock at $100 and don’t mind letting it go at $120…

Then you want to look for the strike price at 120 and see if it is within 15 to 25 Delta.

If it’s lesser than 15 Delta, you might want to wait until the stock goes higher before selling the 120 strike price.

But if it’s within 15 to 25 Delta, then go to the next step.

Step 4: Look at the Mark price and place a Limit Order slightly higher than it.

When you look at the price of any option, you notice there is a “Bid” and “Ask” column.

The Bid is the highest price at which the buyer of the option is willing to pay at that point in time.

The Ask is the lowest price for which the seller of the option is willing to sell at that point in time.

So if you look at the 120 strike price, you will see the Bid is at $1.10.

That means that you can immediately sell your Covered Call at that price and receive a premium of $110.

However, if you’re a smart options investor (which you will be after reading this post :))…

Then you don’t want to sell at the Bid.

Instead, you want to sell as close to the Ask as possible.

This is where we utilize the “Mark”.

The Mark is essentially the mid-price of the option.

And many times, you can sell your Covered Calls at or above the Mark price.

So let’s say you have decided to sell the 120 Strike Covered Call.

It has a Mark of $1.15.

That means you should be able to sell your Covered Call for around that price.

So what you want to do is start by placing a Limit Order for your Covered Call above $1.15.

In this case, you could probably start with $1.17 and see if you get filled.

If you don’t get filled, then we go to the next step…

Step 5: Gradually adjust your Covered Call price until you get filled.

When you gradually adjust your price down, you are doing what’s called “price discovery”.

That means you adjust your price down until you get the highest possible premium that you can get.

So at this point, you’d move your Limit Order down a cent (or two) to $1.16.

If that doesn’t get filled, then you move down another cent.

Basically, you keep moving the price down until you get filled.

This way you ensure that you get the best possible price for selling the Covered Call.

One thing to note…

The market is moving all the time.

So you want to also quickly adjust your Covered Call price down if your initial price doesn’t get filled.

The last thing you want is to adjust as the market is moving down very quickly, and you have to keep adjusting downwards when you could have easily gotten a fill at the Mark in the first place!

Conclusion

Selling Covered Calls can be a great way to generate additional income while holding your stocks.

And if you are able to sell Covered Calls often enough, it can be a very good consistent income.

Now that you know the 5 steps to sell a Covered Call, it’s your turn to get started!

So will you be planning to sell Covered Calls?

Let me know in the comments below!