A lot of people might think that the only way to get cash from your stock investments,
without selling shares that is, is to collect dividends.
However, covered calls are a powerful options strategy that can be used to generate cash
whether or not your stocks pay a dividend.
This means you can earn substantial cash every month or potentially even every week, even
if your stock holdings pay no dividends whatsoever.
So today we are doing a complete overview of the covered call strategy to help you earn
cash flow from any stock.
We’ll start with an explanation of covered call options contracts and how they work.
Then, we’ll dig a little deeper and talk about what impacts the size of the cash premium
you receive and how you might use these in your portfolio.
We’ll also talk about the three potential outcomes of covered calls and how you’ll
be taxed for each of them.
Finally, if you’re not comfortable with covered calls by the end of this video, or
you have a small portfolio, we’ll talk about how you can still enjoy the cash flow this
strategy provides.
So stay tuned for all of that as well as how you can get $50 in free cash to invest today.
Let’s get started.
To start us off, I want to demystify options a little bit by clarifying that there are
really only two types of options contracts.
These are call options and put options.
You can either buy or sell these options contracts depending on your investment goals, making
for a total of 4 basic options strategies.
I previously covered buying call options, specifically long-term call options known
as LEAPS.
Today, though, we’re discussing the opposite, which is selling call options, also known
as covered calls.
A call option is a time-sensitive contract that gives the holder the right to buy 100
shares of an underlying stock or fund.
So if you happened to own a call option for Apple stock, for example, you could act on
that contract, in a process known as “exercising”, to purchase 100 shares of Apple.
But before we can understand why someone might use call options, let’s break down a few
of their key characteristics.
All call options contracts have three qualities you need to be familiar with: an expiration
date, a strike price and a market price.
The expiration date is pretty straight forward.
This is the date that the contract expires, after which the buyer no longer has the right
to purchase 100 shares of the underlying security.
The strike price is very important, as it determines what you’ll pay to exercise the
contract, and when it becomes exercisable.
You may also hear this called the exercise price.
So to continue our Apple example, if you owned an Apple call option with a $150 strike price,
you could exercise the call option to purchase 100 shares of Apple at $150 each.
In short, the strike price is what you’ll pay per share to exercise the contract.
This price is important because if the share price of the underlying stock is lower than
the strike price, the contract probably won’t be exercised.
In this case, it makes more sense to purchase the shares from the market.
However, when the share price is higher than the strike price, the contract will likely
be exercised because it makes it possible to purchase those shares at a discount compared
to the market.
The last quality is the market price, which is what the option contract itself is trading
for.
Options are traded much like stocks, so the price of the contracts will fluctuate throughout
the day and overtime.
There are three main factors that determine the price of options, but we’ll dig into
them more in a few minutes.
So why buy call options?
For investors who think the price of a stock will go up, call options are a great way to
increase your returns.
In doing so, you can buy the “option” to buy 100 shares, locking in your price per
share via the strike price.
In the future, if the stock price goes above that strike price, you can purchase shares
at the secured strike price, which could mean purchasing a stock at a discount.
This allows you to benefit from upward price movement in a stock without having to buy
100 shares in full, which in some cases, can be pretty expensive.
However, this is only one side of the trade.
Someone has to create and sell the call options to buyers, and that’s where we get into
covered calls.
While buying call options secures you the right to buy shares, a covered call is when
you SELL a call option, giving someone else the right to buy YOUR shares.
So instead of paying for the contract, you are selling the contract to someone else and
collecting cash in the process.
This is known as a covered call because the contract is covered or secured by your shares.
If the buyer decides to exercise their call option, you’ll be forced to sell your 100
shares to them, because that’s exactly what the contract entails.
So before we get deeper into covered calls, please understand that when you sell a covered
call, you are placing the future of those 100 shares in the hands of the market and
the buyer.
I’m going to cover some more specifics right now, but keep in mind that when selling covered
calls, there’s always a possibility that you’re forced to sell your shares in the
process.
The beauty of selling covered calls, though, is that you decide the exact conditions of
your options contract and the scenario in which your shares can be sold.
So, if there’s a timeframe or a price point you’re willing to sell your shares, you
can build your covered call around that to get the optimal outcome.
The first requirement is that you own 100 shares of a stock or ETF that is available
for options trading, which should include most securities.
Again, this is because each contract gives the right to buy 100 shares of the underlying
security, and since you’re selling this right to someone else, you need to have the
100 shares available to hold up your end of the contract.
If you don’t own 100 shares, don’t worry, I’ll show you how you can still participate
in covered calls later in the video.
But once you have 100 shares, you can sell or “write” a covered call contract.
At this point, you can select the expiration date of the contract, the strike price at
which your shares will be sold, and the cash premium you want for the contract.
The decisions you make for each of these points will primarily depend on how much cash you
want to generate from this strategy, the price point at which you’re comfortable selling
your shares, and your general outlook on the stock price.
Perhaps the biggest thing we have to break down is the cash premium, which is the amount
of money you’ll receive for selling the covered call contract.
Again, people are paying you for this contract, so you’ll collect cash in your brokerage
account the moment your option is sold.
As I said, there are three factors that determine the covered call premium, and these are the
price difference between the contract’s strike price and the stock’s current share
price, the amount of time until the contract’s expiration and the volatility of the underlying
security.
These factors are also known as intrinsic and extrinsic value.
Intrinsic value is the value baked into the contract based on the difference between share
price and strike price.
In other words, it’s the guaranteed profit you get from the option contract if you were
to exercise it today.
So if you had an Apple call option with a $140 strike price, but it’s trading at $150
per share, the contract guarantees $10 of profit per share.
This means the contract would have about $10 of intrinsic value, and that is going to be
included in the option premium.
However, with covered calls, you’re likely going to be selling call options with a strike
price HIGHER than the share price.
This means they will have no intrinsic value, because they do not have any profit baked
into the contract.
So, when selling covered calls, the premium you’re looking at will typically just be
made up of extrinsic value.
Extrinsic value comes from a combination between the stock’s volatility and the time until
expiration.
A more volatile stock will have a higher premium, because there’s greater potential for price
movements in either direction.
A contract with a longer expiration date will also have a higher premium, because with more
time, there is more potential for price movement to occur.
Of course as someone who is selling covered calls, while you WILL generate more cash for
selecting high volatility, long duration contracts, there is a higher probability that the contract
will be exercised by the expiration date.
So let’s put this all together and walk through a real example with one of my holdings.
I have over 100 shares of Stem stock, so I can sell a covered call on these shares.
Since Stem doesn’t pay a dividend, this gives me the opportunity to generate cash
flow that wouldn’t be possible otherwise.
If we pull up the option chain, which obviously will look a little different depending on
your brokerage, you’ll see I’ve selected to sell a call.
First we see a range of expiration dates that we can sell contracts for, where I’ve selected
September 3rd, which is approximately one month away at the time of writing.
The main number on display is the strike price of the contract, and next to each strike price
we can also see the current market price for the option.
The market price is actually per share, and since each contract represents 100 shares,
you’ll get 100 times the market price.
So with the current share price at $26.73, I might select to sell a call option with
a $30 strike price that is paying a $1.73 premium.
You can see this same strike price will earn me less money if I pick an earlier expiration
date, because it has less extrinsic value, and will earn me more at a later expiration
date, because it has more extrinsic value.
Similarly, the premium increases in value as you get closer to the current share price
because the option is closer to offering intrinsic value.
If I sold the September 3rd option at a $30 strike price, I would get $173 instantly.
But, if the price of Stem rose above $30 any time until September 3rd, the buyer would
likely exercise the contract.
In this case, I would be forced to sell 100 shares of Stem to them for $30, even if the
price went higher than that.
And that’s the risk you take with selling a covered call.
On the bright side, I would get to keep that $173 of premium, making my total earnings
per share $31.73.
On the other hand, if the price doesn’t break above $30 by the expiration date, the
contract wouldn’t get exercised, and I wouldn’t have to sell my shares.
But, I’d get to keep the cash premium I’d collected, earning cash from my holdings even
though they didn’t grow in value or payout any dividends.
Then, I could repeat the process and sell another contract to continue earning income.
So with all this in mind, I think there’s really three approaches to selling covered
calls for cash flow.
The first is that you’re not willing to sell your shares, but you still want to generate
some income off of them.
In this case, you’d select strike prices that are farther away from the current share
price, as well as shorter term expiration dates.
This makes it less likely that the stock price will increase enough for the contract to be
exercised, and therefore less likely that you’ll be forced to sell your shares.
Of course, both of these adjustments mean you’ll earn less cash from your holdings.
So you might have to explore the options chain to find a happy medium between the cash flow
you’re happy with and the likelihood of the option being exercised.
The second is that you are willing to sell your shares, but you want to secure as much
cash as possible.
You may even anticipate the stock price increasing a little.
In this scenario, you’d select a strike price much closer to the current share price,
and maybe even medium to long-term expiration dates.
Both of these choices will drive up the cash premium you receive.
Plus, if you can identify a price point you’d be happy selling a stock at in the future,
you can select it as the strike price to secure a profit level you’re happy with.
If the stock hits that point, you get to sell at your desired price point and you’ve earned
cash on top of it.
If it doesn’t, you can just repeat the process and earn cash until the share price finally
increases.
Of course, this strategy comes with the chance that the stock moves much higher than the
strike price, at which point you miss out on additional profits because you capped your
returns with the covered call.
The last is that you’re worried the share price will decrease, and you want to use covered
calls to minimize your losses.
Another strategy here is to buy a put, but that’s a different option strategy that
requires purchasing a contract.
With covered calls, you can get some downside protection in the form of cash up front.
In this case, you’d likely sell a covered call as close to the strike price as possible,
and maybe even below the strike price.
This would earn you the highest possible cash premium, which should cushion some of the
loss in your portfolio from a drop in stock price.
And of course, you wouldn’t be forced to sell your shares in this scenario, so whether
you cut your losses and sell them on the market or continue to sell new covered calls is up
to you.
And with that, you should have everything you need to know to sell your first covered
call.
But after you collect that first cash premium, there’s two other things to consider.
The first is the closing or assignment of your covered call contract, and the second
is taxes.
When it comes to closing the covered call contract, you may think there are only two
outcomes.
The first is that the share price reaches the strike price.
This means it’s profitable for the other party to exercise their contract, and you’ll
be forced to sell your shares at the strike price.
This is typically done automatically by your brokerage, and you’ll be notified when it
occurs.
The second is that the share price doesn’t reach the strike price and the contract expires
worthless.
At this point, nothing happens - you keep your cash premium and your shares.
You can even repeat the process with another covered call.
But there is a third outcome that you have complete control over, and that’s closing
out your covered call contract before it expires or gets exercised.
To do this, you simply need to BUY a call with the exact metrics that you SOLD a call
for.
So if I sold a covered call on Stem like we looked at earlier, with a $30 strike price
and a September 3rd expiration, I would need to BUY an identical call with a $30 strike
price and a september 3rd expiration.
This cancels out the contract leaving me with no obligation to buy or sell shares.
The caveat here is that the premium for that contract may change over time.
As the price rises, for example, the contract will get more expensive.
So if you see the share price rising and you start getting worried about having to sell
your shares, you will probably lose money buying yourself out of your position.
On the other hand, if the price of the stock drops, the price of the premium will, too.
In this case, you can typically buy yourself out of your position for less than the cash
premium you initially received.
This way, you can actually keep a few dollars but eliminate the obligation to sell your
shares if things turn around.
So now we’ll wrap up with taxes.
The first thing to understand about covered call taxes is that the cash premium is not
technically considered taxable until the call option is closed.
As we said, the call option can be closed by expiring worthless, by being exercised,
or by you purchasing an off-setting call option.
No matter how long you held the call option, or however long its expiration date was, if
it expires worthless or you purchase an off-setting option, your cash premium is taxed as income
under the short-term capital gains rate.
So keep this in mind, as it will be a higher tax rate than long-term capital gains.
However, if the call option gets assigned and you're forced to sell your shares, the
taxation of that cash premium will change depending on how long you held the underlying
shares.
So if you held the shares for longer than a year, you would get the long-term capital
gains tax on the covered call premium and the sale of your shares, while holding for
less than a year would subject you to the short-term capital gains rate.
Keep in mind that all of this is just for out-of-the-money call options, which again
is when you write a contract where the strike price is higher than the current share price.
And this is the typical covered call strategy.
But things get a little more complicated with in-the-money call options, where the strike
price is higher than the current share price.
I’m still not fully knowledgeable on the practical applications of selling in-the-money
call options, so I am not going to cover those taxes here.
But, I’ll leave a link below to a guide on Fidelity that covers all the details.
And now, we have reached the point where I think I have finally covered all of the necessary
details about covered calls.
But there’s one thing left to address, and that’s how you can use covered calls in
your portfolio without owning 100 shares of a stock, because that could require a pretty
large investment in some cases.
The good news is, there are tons of ETFs that use covered calls to generate income for investors.
These ETFs will purchase all the shares necessary and then sell covered calls on specific holdings
or even their entire portfolio.
Then, the cash premium they collect from covered calls gets passed through to investors in
the form of monthly dividends.
One of the most popular options is QYLD, which uses covered calls on the Nasdaq 100 index
to pay a nearly 12% annual dividend.
There’s also XYLD which uses the S&P 500 index, or RYLD which uses the Russell 2000.
There are also some ETFs that employ more complicated covered call strategies, such
as NUSI, JEPI and DIVO.
I’ve covered a lot of these on my channel already if you want to learn more, and I plan
on covering more in the future as they seem to be pretty popular dividend investments.
So hopefully this video helps you guys understand the strategies within those ETFs a little
bit better, but also to understand the covered call strategy on its own.
I do think these ETFs are convenient ways to benefit from covered calls, but if you
can use covered calls yourself, you have so much more flexibility in how you earn income
from your investments.
By the way, if you want to get started with some of these dividend ETFs or passive income
investing in general, definitely check out M1 Finance.
It is hands down the best investing platform for dividend investors, I’ve been using
it for over a year now and it’s only gotten better and better.
There’s a link below if you want to learn more and even get $50 for free when you open
and fund an account.
So check that out if you’re interested, but in any case, thanks for watching and I’ll
see you next time.