Selling Covered Calls vs. Shorting a Stock | The Motley Fool (2024)

FAQs

Is selling a covered call option comparable to selling a stock short? ›

Selling the underlying stock before the covered call expires would result in the call now being "naked" because the stock is no longer owned. This is akin to a short sale and can generate unlimited losses in theory.

Why Are Covered Calls Bad? Covered calls are not necessarily bad. It is recommended not to write covered calls for stocks with high growth potential. The reason is that the upside gain will be missed because you'll be required to sell at the strike price.

You usually wouldn't want to sell covered calls when the market is very undervalued, for example. Covered calls are a useful tool, and in the hands of a smart investor in the right circ*mstances, can be tremendously profitable.

Generally speaking, covered call funds underperform in bull markets, and can outperform in bear or flat markets when their premiums can boost returns.

A call option is ITM when the strike price is below the underlying stock price. Short selling typically involves borrowing a security from the brokerage, selling it on the open market in anticipation of a move lower, and buying back and returning the borrowed shares later.

Many investors regularly sell covered calls to generate a steady income stream. It allows you to target the selling price you would be willing to accept if the share price rises. It offers some downside protection because the premium you receive lowers the breakeven point of the investment.

In a poor man's covered call, investors replace the shares of stock with a deep in-the-money (ITM) long call that has a longer expiration term than the short call. As a result, investors generally spend significantly less money executing the PMCC while reducing the maximum loss potential as well.

Typically, covered calls are sold out-of-the-money above the current price of the underlying asset. Calls that are sold closer to the stock price will result in more credit received but have a higher probability of being in-the-money at expiration.

A covered call can compensate to some degree if the stock price drops, the short call expires OTM, and the premium received from the short call offsets the long stock's loss. But if the stock drops more than the premium received from selling the call option, the covered call strategy begins to lose money.

Is selling puts better than selling covered calls? ›

Selling a call option has the potential risk of the stock rising indefinitely. When selling a put, however, the risk comes with the stock falling, meaning that the put seller receives the premium and is obligated to buy the stock if its price falls below the put's strike price.

A covered call is most bullish when the trader sells calls further from the money. The reason is that options further from the money have lower delta. That means the short calls offset less of their underlying position.

If you do not want to sell the stock, you now have greater risk of assignment, because your covered call is now in the money. You therefore might want to buy back that covered call to close out the obligation to sell the stock.

We are often asked what to expect in terms of a yearly return form Covered Call investing. On average a 12% - 24% annual return or 1%- 2% per month is a reasonable expectation. Using leverage, margin, shorter periods of time, and more volatile stocks these returns can be increased, but with considerably more risk.

Usually, selling covered calls would be a risky endeavor. This is because it exposes the seller to unlimited losses if the stock price soars. On the other hand, by owning the underlying stock, you can limit those potential losses and even generate income.

The S&P 500 Daily Covered Call Index seeks to measure the performance of a long position in the S&P 500 TR and a short position in a standard S&P 500 daily call option. The index aims to reflect higher income generation and lower timing risk by using daily options as opposed to monthly options.

A seller of a call who doesn't already own the underlying shares of an option is selling a naked short call. To limit losses, some traders will exercise a short call while owning the underlying security. This is known as a covered call.

The investor does not have to repay anything to the lender of the security if the borrowed shares drop to $0 in value. If the borrowed shares drop to $0 in value, the return would be 100%, which is the maximum return of any short sale investment.

Disadvantages of Short Calls

The maximum loss is unlimited because the price of the underlying stock may rise indefinitely.

What is the best strategy for selling covered calls? ›

The best time to sell covered calls is when the underlying security has neutral to optimistic long-term prospects, with little likelihood of either large gains or large losses. This allows the call writer to earn a reliable profit from the premium.

The maximum loss on a covered call strategy is limited to the price paid for the asset, minus the option premium received. The maximum profit on a covered call strategy is limited to the strike price of the short call option, less the purchase price of the underlying stock, plus the premium received.

Both short selling and buying put options are bearish strategies that can reap substantial benefits. Short selling involves selling borrowed assets in anticipation of a price drop, while put options involve the right to sell assets at a specific price within a specific timeframe.

Covered calls and short put have the same risk and reward at the onset. However, when the underlying stock price declines and these strategies start losing money, essential differences begin to emerge in the ability of the investor to manage the risk.

After you sell a covered call on XYZ, you collect your premium, and you still receive dividends (if any) and any potential capital gains on the underlying stock (unless it's called away).

On the negative side, premiums are limited, which limits profit potential. You can miss out on a huge upward movement in the underlying stock because you can't sell it without buying back the contract. Worst of all, your losses could be limitless depending on the sort of call option you sell.