In a down or flat market, it can be tough to invest or trade. One way to
raise cash in a slow market, without selling positions, is to sell covered
calls. If you are right about the overall market trend and the trend of your
particular stocks, you can generate a modest return while waiting for overall
conditions to recover.
Selling Covered Calls In A Slow Or Down Market
Selling covered calls is another way to take advantage of a slow or down market.
The tactic is particularly useful when you already have a position in a stock
you intend to hold for some time (at least longer than you expect the market
down trend to be). Selling covered calls can take the sting out of the paper
losses you must endure while continuing to hold the stock.
The upside of a covered call tactic is immediate cash in your account. The
downside is that it ties up your position (until you close the call position)
and a possible assignment of your option, which means you must deliver the
However, if you feel that the market truly is headed down for a while, and you
are right, selling covered calls can put cash into your account immediately
(subject to clearing) without ever having to deliver the stock to the person who
buys the call option.
Meanwhile, you can continue to hold your stock position until the market
Covered Calls - Definitions
A call is an option that gives the holder the right to buy 100 shares of stock
from the selling of the call-option-contract at a specified "strike" price.
The "strike price" is the amount that the holder of a call option will pay if he
decides to exercise the option. If the strike price is $50 and the option is
exercised, then the holder will pay $5,000 ($50 times 100 shares) to the seller
of the option.
The "option price" is the amount that a single option contract costs. Option
prices are always quoted in per-share prices, but a single option contract
always covers 100 shares. The total cost of purchasing an option is always the
"option price" times 100 shares.
An "in-the-money" option is one whose strike price is lower than the currently
trading price of the option. The total "option price," however, is usually high
enough to prevent the option from being exercised for an immediate profit. When
the stock price rises high enough so that the total strike price paid plus the
total option price is lower than the total market value of the shares, there is
an incentive to exercise the option. Often, option holders will simply sell the
option for a profit rather than exercise it. Many times, the purchaser of the
option in this case is someone who original sold the option, with the intent to
prevent his actual shares from being called.
A "covered call" is a term describing a call that is sold by a person who
already owns enough shares of the stock in question to deliver those shares, if
the option is assigned.
"Assigned" means that the person holding a call option makes the decision to
exercise it, pay the strike price for the shares and have the stock delivered to
him. The "assignment" occurs when the exchange tells the seller that someone has
exercised the option and the shares must be delivered. Generally, no action
needs to be taken by the option seller; the sales proceeds appear and the stock
is removed from your account.
Note: You should probably not try this tactic as your first experience with
options, however. Start with simply purchasing options. As a purchaser, you
potential loss is always limited to the amount you spend for the option itself.
When you decide to sell a covered call option, there are several chooses you
need to make:
-Number of shares
For expiration dates, there are usually several choices of varying length. The
longer the expiration date, the higher the premium for the option will be, but
the more risk you take that the stock might be called.
There are also usually numerous choices for a strike price. In general, the
number of outstanding options at any time is higher for options that are
"in-the-money." Choosing an option contract with a higher number of outstanding
contracts means greater liquidity. Higher volume can provide better pricing, but
also "fresher" bid/ask data (which can sometimes be a problem).
For a "covered call" tactic, the number of contracts you can sell is limited by
the total number of shares you already own. You must have at least 100 shares to
write a covered call contract. You can sell any number of contracts for which
you own 100 shares. For example, if you own 850 shares of a stock, you can sell
up to 8 covered call contracts.
After you have made these choices, you are ready to actually sell the covered
call. All you need to know is the ticker symbol for the call option.
Most brokerages provide an "options chain" capability for easy lookup of the
ticker symbol. Although there is a standardized convention for option ticker
symbols, clicking on the "options chain" link at your online brokerage is a lot
Selling A Covered Call
When you decide to sell a covered call option, you place an order with your
broker, just as with any sales order.
The actual steps to place the order vary by brokerage; check with your broker
for the exact procedure.
As with any sales order, you have the choice of a market or limit order.
Pricing is determined by a bid/ask system, just as with stocks and the same
cautions about marker orders exist with options.
The exact price offered for any option is set by the market. The theoretical
"correct" pricing involves mathematics that is beyond the scope of this article.
Before placing an order, verify the date of the most recently traded option with
the same strike and expiration date. Sometimes, the bid/ask data shown for a
particular option can be quite old for a thinly traded contract. If so, do not
place a market order to sell the contract.
Receipt of Proceeds
When you sell a covered call, the proceeds from the sale appear in your account
as cash. The amount earns interest or offsets your total margin balance, just as
a sale or other check deposit would (and unlike short sale proceeds).
However, while the option contract is open, a restriction is placed on your
shares. In general, the underlying shares for the stock behind a covered call
cannot be sold unless the open call contract is first closed. If the shares were
sold prior to the option position being closed, the call would become a "naked"
call. Generally, a brokerage firm will not allow an open option contract to
convert from covered to naked status while the position is still open.
In addition, the value of the shares behind your open covered call position will
not be used to determine your overall margin capability (generally). Selling a
covered call lowers you margin capability (in most cases).
Selling covered calls provides you with the following benefits in a down market:
-Cash proceeds, which can offset the paper losses during a down market
-The ability to "set your price" for selling the underlying stock
-The holding period for the underlying stock is unaltered by selling the calls.
(Important if you are close to the long-term capital gains period)
If all goes well with the "selling covered call" strategy, the option expires
without you having to ever do anything. At that point, if you still think the
market is headed down, you can sell new covered calls against the very same
shares of stock.
The "set your price" concept involves picking a strike price at which you would
happy to sell the stock. For example, if you original envisioned selling the
stock at $50 a share, but the current price is just $42 a share, it may be
beneficial to sell a covered call with a strike price of $50. This is what you
would have sold for anyway, but by selling the covered call, you increase the
total proceeds from your sale.
The risks associated with selling covered calls are largely related to the stock
price rising unexpectedly and include:
-Having to close your call option position by buying the option at a higher
price than you sold it for
-Having to deliver your shares as a result of the call option being assigned to
-Limiting your ability to sell the underlying shares while the option is still
The last risk is probably minimal, as the covered call tactic is primarily
designed for situations where you want to continue holding a stock during a down
Before embarking on any covered call sales tactic, you should determine if you
would be comfortable actually selling the stock if the strike price were
reached. If not, rethink your approach.
More Information On The Selling Covered Calls Tactic
For an excellent discussion on the covered call strategy, we recommend the
following book: "The Short Book On Options, A Conservative Strategy for the Buy
and Hold Investor " by Mark D. Wolfinger
Comments may be emailed to the author, Robert V. Green, at