What are covered calls in options trading?

Advantages of covered calls

Here are some key benefits for using a covered call strategy:

• Generate income: Covered calls provide a way to earn extra income on stocks you already own. As long as if you’re comfortable selling your shares at the strike price, the premium you collect is yours to keep.
• Reduce risk: The premium from selling a covered call acts as a buffer against potential losses if the stock price declines. It effectively lowers your breakeven point on the stock.
• Profit in sideways markets.: Covered calls perform best when the underlying stock trades in a range. You keep the premium but are less likely to have your shares called away.

Historical performance of covered calls

Historically, covered call strategies tend to perform best in stable and mildly bullish markets. For instance, during periods of market stability, covered calls have provided consistent income while offering some downside protection. However, during strong bull markets, the upside potential is capped, which can lead to underperformance relative to a fully invested long-only portfolio.

How to sell covered calls

Ready to start selling covered calls? Here's how to do it:

1. Choose the right stock. Ideally, pick a stock you wouldn't mind parting with if the price rises above the strike. Find stocks with moderate volatility.
2. Decide on a strike price and expiration. The strike is the price you're willing to sell at. A shorter time to expiration means the option is less likely to be exercised but the premium will be lower.
3. Sell the call option in your brokerage account. Platforms can make it easy to sell covered calls, like BMO InvestorLine Self-Directed.
4. Monitor the trade. If the option expires worthless, you keep the premium and your shares. If the stock rises above the strike, be prepared for the possibility of assignment.

To write a covered call, you need to buy the stock first and then sell the call option. Find a good stock that you think will appreciate and remember that options deal in 100 share increments.

For example, if you bought 100 shares of a stock trading at $50, you could sell a $55 call option expiring in 6 months for a $4 premium per share. If the stock stays below $55, the option will expire worthless, and you keep the $400 premium ($4 x 100 shares). If it rises above $55, your shares will likely be called away, but you still profit $900. This is made up of the $400 premium you collected for selling the option, plus $500 from selling the underlying stock at $55 versus your $50 cost basis.

So, there are two steps to writing a covered call:

• Buy 100 shares of XYZ stock.
• Sell to Open one XYZ call option, which you select the expiration date and strike price.

If you own 500 shares, you can write between one and five covered calls. There is no requirement that you sell call options on all your underlying shares. The choice is yours based on your outlook and desire for income. For example, in this case, if you sold two covered calls and the underlying stock hit the strike price, you’ll have 200 shares assigned and 300 shares remaining. This is a way to hedge your strategy in case of a sudden bull run — you would still own shares that participate in the strong price appreciation without getting called away.

The downside of covered calls

While covered calls have many advantages, there are some risks and drawbacks to be aware of:

• Missing out on large gains: If the stock price rises significantly, your upside is capped at the strike price. The potential missed profits are theoretically unlimited.
• Tax consequences: If your shares get called away, it counts as a sale and may trigger capital gains taxes in a taxable account, especially if you've held the stock for a long time and have a very low cost basis.
• Early: The owner of the call option can exercise at any time. If the stock rises above the strike price, you may be assigned and forced to sell your shares before expiration.
• Opportunity cost: By selling covered calls, you give up some potential gains in exchange for income now. If you’re extremely bullish on a stock, you may prefer to just hold it.

Advanced covered call strategies

Once you're comfortable with the basics, you can consider some more advanced approaches.

Covered call laddering

Laddering involves selling covered calls at different strike prices and expirations on the same underlying stock. This spreads out your income and risk. For example, if you own 300 shares of a stock trading at $50, you could sell:

• 1 call at a $52.5 strike expiring in 1 month
• 1 call at a $55 strike expiring in 3 months
• 1 call at a $60 strike expiring in 6 months

If the near-term calls get assigned, you still have longer-dated ones working. If the stock rises slowly, the far out-of-the-money calls may expire worthless.

Covered calls in an RRSP or TFSA

Covered calls can be an attractive strategy for generating income in retirement accounts like RRSPs and RRIFs, as well as TFSAs. Since these accounts are tax-sheltered, you don't have to worry about triggering capital gains if your shares get called away.

However, there may be restrictions your brokerage places on options trading in registered accounts. For example, they may only allow selling calls that are fully covered by shares in the account.

Combining covered calls with cash-secured puts

While covered calls profit from a neutral to slightly bullish outlook, cash-secured puts are used when you’re neutral to moderately bearish. The strategy involves selling a put option and setting aside the cash to buy shares if the put is exercised.

By combining covered calls and cash-secured puts on the same underlying stock, you create a covered strangle — a market-neutral options position that profits as long as the stock stays within a range.

What is a covered call ETF?

A covered call exchange-traded fund (ETF) allows an investor to use a covered call strategy without having to manage the strategy themselves. The ETF does it for you. If you like the idea of covered calls but would prefer someone else handle the execution and maintenance of the strategy, a covered call ETF can be ideal. These ETFs hold underlying securities (usually stocks) and sell call options against them, passing on the income to shareholders.

For example, a covered call ETF traded on the Toronto Stock Exchangecould hold a portfolio of Canadian bank stocks and would write covered calls against them on an ongoing basis. This is one way to add covered call exposure to your portfolio with a single product.

A summary of covered calls option trading

Covered calls offer a way for investors to generate income from stocks they own while providing some downside protection. By selling call options, you get paid a premium to potentially sell your shares at a higher price in the future.

This strategy performs best in neutral to slightly bullish markets. It allows you to profit from a slow rise in the stock while cushioning against a modest decline. The main risk is missing out on a large rally since your gains are capped at the strike price.

Covered calls can be used in a variety of ways —- from a conservative income strategy for retirees to a more active approach for options traders. They also pair well with other options strategies like cash-secured puts.

While covered calls are relatively straightforward as far as options go, make sure you fully understand the risks before implementing them in your own portfolio. Consider your outlook on the underlying stock, your risk tolerance, and how options fit into your overall financial plan.

If you're ready to start trading covered calls, we provide a robust platform for options investors through BMO InvestorLine. You'll have access to extensive options chains, risk management tools, and educational resources to help you invest. Reach out to us today to learn more about adding covered calls to your investment toolkit. With the right approach, they can be a valuable source of income and returns in your portfolio for years to come.