Passive Income Idea: Sell Covered Calls

If you didn’t have time to look at the introduction to options post you can find it here: Option Payoffs and Profits Illustrated – Fired to FIRE (fired-to-fire.com), and I’d recommend having that post open so you can refer to as we go through this. On this post we’ll be discussing the idea of selling calls on stock that you already own, or will purchase in combination with selling the calls. This is referred to as a covered call. An uncovered call would be selling calls where one doesn’t own the underlying security.

Calls and puts are bought and sold in contracts. Contracts are on 100 shares worth of the underlying security. I’m going to continue doing the calculations on one share for illustration purposes, and to mirror the prior post, but in practice you’d have to own 100 shares for every call contract that you wanted to sell to be a covered call.

Last time we discussed a 420 strike call on Paycom (PAYC). Paycom had been trading at 409. Here one was paying $5 to enter that deal, to have the right to buy at the 420 strike price. That would mean the stock would have to go to 425 to break even by the expiry date. You can see in orange, on the right chart, the profit.

In this case you are paying the $5 but what if you wanted to be on the other side of that trade and receive the $5? The payoff and profit charts are the mirror image (below). In this headspace maybe you thought it was going to go down in the near term and think, “yeah, sure I’d like to be a premium receiver! I could use a little extra cash.”

But nothing is for free. If you are selling a call you must sell the stock at the strike if the other side is in a favorable position. If you were to sell a call like this without owning the stock it’s referred to as an uncovered call. You’ll notice the risk is boundless in this case. For example if the price were to go up to $450 at the expiration date and you had promised someone to sell it to them for $420, and you didn’t own the stock, you’d have to go buy the stock for $450 and then sell it to them for $420, netting a -$30 payoff. The $5 premium you collected would soften the blow to -$25. I’ll let you ruminate if it went up to $1,000. Don’t think you can just always receive that $5 riskless. Now what if you had the stock already when you elected to sell the call?

I think profit on a stock is easier for most to think about. It’s the price when you sell minus the purchase price, in this case $409:

If we had the stock prior to selling a call we wouldn’t need to go out into the market to buy a share, if the stock went up above the strike price. Let’s look now at the combination of owning the stock and selling a call:

Plus

Equals

We see that once we hit a price of $420 we’re capped, as the gain in the stock is offset by the fact that we need to sell it at $420. It may be helpful for, comparison purposes, to look at only owning the stock (in orange) and then a portfolio where one is also selling a call (in blue):

If the stock really skyrockets one would be better off had they not sold a call. The fact is though one is still making money, just not as much. Flip side is if the stock doesn’t move too much from it’s current price, of $409, or goes down one would be better off selling the call, as they’d be collecting the $5 premium from the call. It might be a good exercise to think about why you’d use this strategy.

That being said this strategy still comes with risks. If you do sell calls on a stock you really believe in and then the stock does jump way above the strike price of the calls you sold it can sting your heart. One time I was selling calls on a stock I owned and it jumped so much that I was unable to buy back right after… Even though I had made money on this I felt bad because I had lost a stock that I believed in, and not made as much as I could have. It’s funny how our psychology plays with us sometimes. I’m not saying don’t do it but just understand the circumstances when you’ll be better or worse off, and try to think/research through the probabilities of those happening.

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