What is a Covered Call
A covered call is an options strategy in which an investor holds a long position in an underlying security and sells a call option on that security. The call option gives the buyer the right to purchase the underlying security from the seller at a predetermined price (the strike price) on or before a certain date (the expiration date).
Here is a chart describing the key components of a covered call:
To summarize, in a covered call the investor sells a call option on an underlying security that they already own. If the option is not exercised by the buyer, the investor keeps the premium as profit. If the option is exercised, the investor must sell the underlying security at the strike price. The investor's profit is limited to the premium received, but they are also exposed to the risk of having to sell the underlying security at a price lower than its current market value.
Covered Calls Selling
Also known as a buy write strategy or covered calls writing, covered calls selling entails buying a stock and selling a call option against it. This strategy can be used for different purposes including risk management or income generation, however should be done within the context of an overall portfolio. In general, covered calls selling is a strategy that outperforms during sideways and down markets, however there are various details to consider when implementing such a covered calls strategy. First, an investor should define their goals and then decide whether or not to incorporate covered calls selling to match their goals. For example, does the investor want to add yield to their portfolio, are they looking to hedge certain risks, are they looking to be active or passive? These are some of the questions that investors must ask themselves when deciding whether or not to use a covered calls strategy. Many investors typically look at a one view mirror and focus on the income generated by covered calls selling, which often leads to underperformance. Second, if an investor decides to incorporate covered calls selling within their investment strategy, they should target a certain allocation for that strategy (ex. 25% or 50% of the total portfolio). Third, the investor has to research the types of securities on which they would implement the covered calls selling to achieve their goals (ex. would it be a single stock, a basket of securities, or an ETF, or a combination? what sector would be targeted? what premium levels are being desired? etc.). Fourth, once an investor figures out the type of security on which to implement covered calls selling, a careful analysis between the different call options on that security should be performed.
Covered Calls ETF
Instead of covered calls selling on a specific stock, investors can sell covered calls on an ETF OR invest in an ETF that employs covered calls selling within it. Let's look at both in more detail:
(i) Selling covered calls on an ETF: an investor would buy an ETF and then implement covered calls selling on it (ie. selling a call option on the same ETF they bought). This has to be a liquid ETF that has an option chain and investors should ensure that there's adequate volume on the options of that ETF (unless the investor does not mind taking large liquidity risks). Typically the premium received from selling calls on an ETF would much lower on average than the premium received from selling calls on a single stock. With that said, this would be a lower risk covered calls strategy and could offer strong annual yields during periods of instability and market dislocation.
(ii) Investing in an ETF that employs covered calls selling: instead of doing it themselves, investors can simply invest in a Covered Calls ETF that implements covered calls selling on multiple securities. This offers an option that is more passive while producing better diversification, and with less risk of execution if the investor is novice. It does however come at a price as the management fees for a Covered Calls ETF would be much higher than that of a regular ETF. Nevertheless, the Covered Calls ETF space has become more and more competitive that asset managers are reducing their fees, making it more attractive for investors. One important thing to note is that each covered calls ETF manager is different and it is important to analyze the holdings of the ETF as well as the manner by which covered calls selling is performed on the holdings (how far out of the money, what is the roll over strategy, etc.).
Covered Calls Strategy
The strategy of selling covered calls has a track record of outperforming the market if done correctly. You can see how different covered calls strategies performed versus other strategies and indices here. There is a difference between a covered calls strategy focusing on single stocks versus on that is focusing on ETFs versus another that is focusing on specific sectors, and so on. As a result, investors can experience very different results with different covered calls strategies. It is important for the investor construct a covered calls strategy in relation to their overall portfolio and investment goals. Not doing so will often result in underperformance relative to both the market and the investor's own objectives.
Top Fixed Income Covered Call ETFs in Canada
For investors with investable assets of over $1 million, contact us for risk-managed investment advice on fixed income covered calls.
FAQ on Covered Calls
Covered Calls Writing
It is the same as covered calls selling, which entails selling a call option on a security that one holds. Please refer to the Covered Calls Selling section for more details.
What Is Covered Calls
Please see above.
Options Covered Calls
Please see above.
Covered Calls Option
Please see above.
Stock Covered Calls
Please see above.
Covered Calls Example
Buying General Electric stock (GE) and then selling a call option on the stock. The call option could be at the money or out of the money.
What Is Covered Calls Options
Please refer to the Covered Calls Selling section for more details.
Best Stocks For Writing Covered Calls
The best stocks are those that match your strategy and investment goals. There is no one standard basket of stocks that offers the best covered calls strategy. Also some stocks can be strong buys on a stand-alone basis but not within the context of a covered calls strategy.
Best Stocks For Covered Calls Writing
Please see above.
Best Stock To Sell Covered Calls
Please see above.
Covered Calls Options Strategy
Please refer to the Covered Calls Strategy section for more details.
How Do Covered Calls Work
An investor would buy a specific stock and then sell call option against that stock. The investor would choose the strike price and maturity of the call option they would like to sell.
Risk Of Selling Covered Calls
The primary risk, relative to holding a stock without selling covered calls against it, is for the stock to appreciate beyond the strike price of the call option thereby limiting gains.