Ultimate Covered Call Strategy Guide: Passive Income Generator

I recently wrote about how I employ the option wheel strategy to earn a consistent income from selling options. This involves selling puts and calls repetitively. This method allows you to collect a consistent premium on your stocks of choice with much lower risk than buying naked options.

This guide will go into detail why I think sometimes the option wheel strategy is inferior to just owning covered calls. Covered calls are a very easy to understand strategy that allows for you to benefit greatly from slightly bullish to bullish markets. They are relatively safe on the right stocks and allow for you to collect consistent premium.

This guide will show you everything you need to know about the covered call strategy and hopefully answer all the questions you had!

 

Who is this post for?

If you have no idea what options are, then you should probably read up on basic option theory and understand what you’re getting into before putting your money on the line. However, I think the covered calls are one of the easiest strategies to implement and understand. Therefore, if you have a basic understanding of call and put options, you should be able to get use out of this guide.

As a reference, I had never sold options before getting into this strategy. I used to always buy call and put options, losing more often than not.

 

What is a covered call?


A covered call is the opposite of the cash secured put. Instead of selling puts, you are selling calls. This means that if the price of the underlying stock goes above your strike price, you will need to sell the stock at the strike price.

It is called covered because you need to already own the underlying shares in order to sell calls. If you didn’t have the 100 shares to begin with, then this is called a naked sell which most brokerages won’t allow you to do because they would essentially just be lending you money (in case the option was called away).

Let’s continue with the below example:

You purchase 100 shares of AAPL at $150 per share (total of $15,000 market value). You then sell a call option expiring at the end of the week with a strike of $155 for a premium of $1 (or $100). Two outcomes can occur:

  • The price of AAPL is $154 at the end of the week. Your option expires worthless and you keep the $100 in premiums because the price is under the $155 strike price
  • The price of AAPL is $156 at the end of the week. Your option is exercised which means you must sell your 100 shares of AAPL at $155. You also get to keep your premium however as the option has expired. This scenario means your option has been “called away”.

Using the above example, if the price of AAPL was $175 at the end of the week, you would still need to provide the 100 shares of AAPL at $155 which means you’ve locked in a $20 loss per share (Total $2,000). However, since you already own 100 shares, you will never lose money when the price goes up, but your gains are capped depending on your strike price.

 

How do I choose the strike prices of my options?


There are probably much more sophisticated ways to do this but I usually just target a delta value above below 0.25 and call it good. Robinhood lays it out quite nicely and even has a “Chance of Profit” column which is not the same thing as the Delta value but derives its probability from the delta.

For example, the stock below is Airbnb. The current price is $157.88 so I would sell a put below the current price. I choose my price based on delta values and how I feel about the stock.

If I think the stock has momentum to go higher, I will sell the $155 put and collect $1.27 (or $127) of premium. If I’m not feeling passionate about the stock and am indifferent, I will go with the lower strike and sell the $152.5 strike and collect a $0.7 ($70) premium.

 

Theta is your best friend

Theta is the Option Greek for time decay. When you are buying an option, time decay eats at your premium and is one of the main reasons you always end up losing money. When you are option wheeling, you are continually selling options so theta becomes your best friend.

Every day that you near expiry, theta helps you with your trade just a little bit more.

Options Theta Explained | Option Alpha

 

Implied Volatility (IV) Crush

Otherwise known as IV Crush. IV Crush is probably the single best thing to happen to option sellers and executors of the Option Wheel. When a stock experiences a huge run up, implied volatility increases drastically which will also increase the value of the premium.

Many people like to buy a call or put option when they see a huge move in the price because they want to get in on the action. The problem is, the option is so expensive at this point because of the implied volatility has skyrocketed. For option sellers, this means you can collect a huge premium.

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More times than not, a stock that’s doubled in price overnight will likely not experience the same move the next day. The price could move say 10%-20% in either direction but it is still a far cry from 100%. This means implied volatility could collapse rather quickly which means the value of the option could move quickly as well. This is referred to as IV Crush.

For example, when AMC was having its big run in q2 of 2021, IV went up to 600% at one point! This is absolutely insane. If you bought a put thinking the price would go down, then you would have been right. The stock promptly went from its highs in the $60s down to the $50s in one days. You would think that owning a put would mean you earned money. However, because the price movement downward was much slower than the previous days, the implied volatility went down to something like 300% (which is still insanely high). This meant that even though you were betting the right price movement, the implied volatility move meant your option actually lost value!

 

How much money do you need?

Nothing is free in this world. You need money to make money. Selling a covered call means you need to have enough money to own 100 shares of the stock outright. Depending on the stock you are trading, this can mean anything from $1000 to $100,000.

For example, let’s say you want to option wheel AMD stock. The current price of the stock is around $100. Since all options are 100 shares per contract, this means you need $100 x 100 = $10,000 to sell 1 put contract. From my experience selling weekly options, I’ve been able to collect about $100 on average per week doing this as AMD has a higher than average Implied Volatility.

That means $100*4 = $400 per month, or about $5,000 per year in premiums. This translates to roughly a 50% annualized return by selling AMD puts which is not YOLO wallstreetbets type of returns, but will more than suffice for my purpose!

 

Trading covered calls around earnings

Trading around earnings as a whole is risky because volatility is at its highest point during these weeks. If you actually look at the implied volatility for a stock around earnings season, you can see that it always goes up.

Even if the price of the stock doesn’t move much, the implied volatility can be much higher than expected because it’s what the market is anticipating. This means calculating IV using Black Scholes vs what you see in the market can vary drastically during earnings season. You can have a stock move sideways 1% leading up to an earnings release, and then have it go up or down 10% in the next day.

This additional IV means juicier premiums around this time. Your premiums will be elevated which means your “breakeven price” will be higher. However, you are of course running the risk that the company blows out earnings and your stock goes to the moon. This means you will be called out of your stock by the end of the week

 

Examples of selling covered calls


There’s no better way to explain how to sell covered call options than by example. I will use QQQ as my example and then use the option chains in Robinhood to illustrate my point.

I use Robinhood to trade options because it is 100% free. Robinhood, along with Webull and Sofi are some of the absolute free options to trade options. While Chase Youinvest or Etrade allow you to trade vanilla stocks for free, options still carry a price of $0.5-$1 per contract. This adds up quickly and can quickly eat into your profits.

Here is the price history of the QQQ:

As of Nov 12, 2021, it is trading at $391 per share. To sell a covered call, you first need to sell a call on the stock.

I like to use weekly stocks with a delta of 0.2. This reduces the chance of the stock reaching my strike price from my experience allowing me to keep the premium.

Here is a screenshot of selling a call on QQQ. I chose the 399 strike which has a Delta of 0.19 and a chance of profit of 84%. As you can see from the expected profit and loss graph, my max profit on this trade is $98 because when you sell an option, your max profit is capped at the premium you collect.

However, Robinhood will not allow you to sell a naked a call because if the price goes above 399, someone is on the hook to provide the shares at $399 to whomever bought the call (the other side of your trade). This is why you will need 100 shares of the stock in order to sell covered calls.

So now I will buy 100 shares of QQQ as well as selling this option and you will get a profit loss graph like the following:

covered call option pay off chart

As you can see, OptionStrat.com illustrates this out perfectly. If I sell a 399 strike call against 100 shares, this means I receive a $102 premium. My max profit of $938 according to this chart means if the stock reaches $399, I not only keep the $100 premium, but also realize the gains on the underlying stock. In this case, QQQ reaching 399 from a price of 391 means a profit of $836.

 

Rolling the covered call to next week

Now we are on to more advanced topics. If the price of your stock reaches the strike price of your covered call, you will be forced to sell all the stocks you hold. You might not want to do this because you think the market will keep going higher. Another reason to not want to be forced into a sale is because of capital gains. I’ve owned QQQ for quite some time and if I sold 100 shares of the stock, I would be on the hook for a big long term capital gains tax bill since I’ve made so much over the years in unrealized gains.

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What you do in this case is either:

  • Close the position for a loss (you can’t win every time right)
  • Roll the option to the next week

In the second example, what does that mean to roll the option? Simply it means to sell your current option and buy another option one week (or two week, or one month etc) out. You’re simply rolling the obligation of the option further down the line. Essentially, you are just extending the time you have to get the result you are hoping for.

If your covered call is in the money, meaning you will have to sell your shares and this is something you don’t want, rolling your option is definitely one way to accomplish this. Let’s use this example below

Let’s say I had 100 shares of QQQ and I sold a covered call with a $394 strike expiring Nov 15. It is Nov 15 now and the price looks like it will be above 394 at the end of trading day on Nov 15. I don’t want my shares to be exercised so I want to “roll the option”.

This means I’d have to “buy back” my original option for $1.97 which will most likely mean a loss from the original premium I collected. However, I can now look at the Nov 19 expiration date 4 days out and see that I can sell another covered call at the 398 price and collect a $2.03 premium. This means I have extended my option out 4 days and increased my price target to $398. I even collected a net $0.06 in premium.

Of course the price of QQQ can easily go past $398 by Nov 19 close but you can continually do this until you reach your desired result. Unfortunately, this means if you are looking to achieve consistent premiums weekly, you are not collecting premiums anymore as you’re constantly rolling out the option.

 

Why selling covered calls beats selling cash secured puts


Selling covered calls means you purchase 100 shares of a stock, as well as selling an option with 0.2-0.25 delta. This means you collect a premium, as well as realizing any MTM gains on the stock up to the strike price of your short call.

Stocks in the long term are generally bullish which means you want to have a long term bullish outlook on your stocks.

For both strategies, you need enough money for 100 shares of the stock. For covered calls, you need to outright own 100 shares. For cash secured puts, you need enough cash collateral for 100 shares. Therefore, the upfront capital is not different for both strategies.

However, for cash secured puts, you only get the premium on the stock. If I sell a $145 put on AMD stock, I collect $2.14 in premiums. This means my maximum profit is $214 on this trade. If the stock moves to $145 upon expiration, this only allows me to buy the stock at $145 and that’s it. You can see this from the Optionstrat screenshot below

For a covered call, let’s say I sell the $150 strike on AMD, my maximum profit is therefor $480 because of the premium and the stock appreciation.

Again this is because I need to have 100 shares of the stock in order to get into a covered call. I’m not saying that a covered call is always better than a cash secured put. If you anticipate the stock going down in price, then a CSP is advisable.

However, over the long run, I just find with high quality names, a covered call strategy consistently beats selling puts.

 

Selling covered calls on long term holdings


For those who already have a large portfolio of stocks and/or etfs, selling covered calls can be a great way to generate a little investment income on the side.

I retired early in 2020 with a portfolio of various ETFs and single name stocks. I regularly sell covered calls on my existing holdings far out of the money to collect small but low risk premiums.

For example, my portfolio consists of the following ETFs

  • 8000 shares of QQQ
  • 200 shares of TQQQ
  • 700 shares of SPY
  • 200 shares of ARKK
  • Various other ETFs

This isn’t my whole list of stocks and ETFs of course but we will keep it simple with this example.

Owning QQQ, the most liquid NASDAQ ETF out there means I can sell covered calls against my existing holdings easily. In fact, QQQ and SPY are the most liquid ETFs out there and there are multiple option contracts per week. This means you have so much choice and liquidity that you don’t need to worry about huge bid/offer spreads that less popular ETFs might have.

 

Selling covered calls against QQQ

Using the above example, we can try selling covered calls against QQQ. Since I have 800 shares of this, I can sell 8 contracts. Generally, I like to follow the below criteria when it comes to selling Covered calls against long term holdings:

  • Choose a strike price with a delta of 0.2 and below
  • Aim to sell options when prices are near all time highs

I’ve owned these ETFs for a long time now and being forced to sell them would result in a massive tax bill which is completely unnecessary for me. Therefore, I like to be much more conservative when selling calls against long term holdings. If I can achieve a 2% monthly return, that is more than enough for me (still 24% annualized!). The name of the game here is not to generate big money, but consistent safe income.

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Generating passive income from covered calls

As you can see from the above, it is quite easy to generate a consistent stream of passive income by selling covered calls. Whether you’re doing it on long term holdings or short term plays, you can obtain a healthy passive income stream throughout the year.

However, like any investment, nothing is guaranteed. The markets do not always go up and sometimes they go up too much. The right conditions are needed for covered calls to work and sometimes you will lose money. However, over a one year period, I’ve always made a decent return.

 

What are the risks of selling covered calls?


Like literally every single thing in financial markets, there is no such thing as a free lunch. There is ALWAYS risk associated with a trading strategy no matter how safe it might look. Options in general are just one big dumpster fire of risk. It’s compared to a casino for a reason.

You win big, and you lose even bigger.

Covered calls are no different. There are risk of selling covered calls just like any other strategy out there.

 

When will you lose money trading the options wheel?

Covered call strategy has two downsides:

  • The underlying stock moving down in price
  • The underlying stock moving way above your strike price

The first option is pretty obvious. If you buy 100 shares of AMD stock at $147.75 and then sell a $150 strike call for the next week expiry, you’ll collect $2.66 (or $266 in premium).

If AMD stock price goes down to $140 the next week, this means you’re now sitting on a loss. This loss is mitigated by the premium you collect however.

On the stock, you’ll have a $147.75 – $140 = $7.75 loss per share

$7.75 – $2.66 (the premium for the call) = $5.09 net loss 

This means you will have an unrealized loss of $775 on AMD, but because you sold the option and collected the premium, your net loss is $509. Nevertheless, it is still a loss. However, if you’re selling covered calls on high quality long term stocks like AMD, this isn’t as big of an issue. The stock price will recover at some point in the future. It could be next week, next month, or next year. You might have to hold on longer than you hoped but it will recover eventually.

 

Opportunity Cost of the underlying going above your strike

The second option is if the price of the underlying goes above your strike price. If AMD stock goes to $155 the next week, this means your gains are capped at $150 since that’s the strike you chose. This means, at the end of the week, you must sell AMD shares at $150.

$150 – $147.75 = $2.25 (This is the profit on your stock)

$2.25 + $2.66 (premium collected on the option) = $4.91 net profit

Had you not sold any call options, you would be sitting on a larger profit ($155 – 147.75 = $7.25).

Because you collected the premium on the option, your net profit will be $491 instead of $225. This is why there is a column in the Robinhood layout for “Break Even”.

 

Buy stocks you want to hold long term!

Perhaps the most important thing to do to manage risk when trading covered calls or the Options Wheel is to choose stocks you are long term bullish on. These are stocks that you wouldn’t mind holding if the market were to crash because you know it will recover at some point.

This means you should stick to mostly blue chip stocks to reduce risk. Of course, there is never a free lunch and more stable stocks means less volatility which equates to smaller premiums.

 

Using a spreadsheet to track Options Wheel


I’ve been “wheeling” and trading covered calls for awhile now. It’s certainly not the most sexy way of trading and you won’t see anyone from Reddit’s /r/thetagang (Option Wheel afficionados) posting on /r/wallstreetbets anytime soon. Option wheel is about boring but consistent income. It’s not a get rich quick strategy but rather one that offers small gains and doesn’t blow up your account.

Once you start trading, you’ll quickly realize you are executing many trades. If you pick 5-10 stocks like I do to wheel on weekly options, this means you are executing 5-10 trades a week at minimum. Sometimes, you might want to close out of the option or roll it to the next contract which means executing even more trades.

All of this adds up quickly and no brokerage has a good tracking method for keeping tabs on the premiums your collecting and what is getting assigned and what is not. You need to do this on your own which is why I use my personal spreadsheet for this project.

You can access my options trading spreadsheet and use it for yourself to keep track of wheel trades.

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