Covered Calls: Beyond the Basics

While the covered call is a basic strategy in options trading, understanding more advanced concepts like delta, extrinsic value, and implied volatility can help an investor strategically select the stock to buy and the option to sell. Here we'll go beyond the basics of the covered call to help explain some common challenges to help traders—those who might have previous experience with covered calls—fine tune their approach. For a primer on the strategy, consider reading Options Strategy: The Covered Call.

The time left until expiration, implied volatility, and the distance between the strike price and the underlying stock's price are the key factors to consider when sizing up various options for a covered call. The first two factors—time and implied volatility—determine the extrinsic value of an option.

• Intrinsic value: The amount an option would be worth if it was exercised today. If XYZ is trading for $50.75 and the 50-strike call is trading for $1, it has $0.75 of intrinsic value because the long call holder can buy (call) the stock for $50 and sell it for $50.75, realizing a $0.75 profit on the stock trade, excluding transaction fees. 
• Extrinsic value: Any value in the option beyond intrinsic value. In the XYZ example, the extrinsic value is $0.25, or the options premium ($1) minus the intrinsic value ($0.75).

Options with more time left until expiration will typically have more extrinsic value, but that doesn't mean the covered call investor necessarily wants to pick the options with the furthest expiration. That's because the more time in the covered call, the greater the chance the stock will move above the strike price, which increases the probability of assignment. 

Also, time decay isn't linear, and options typically lose value at a faster rate as expiration approaches. 

If the goal is to generate income from selling extrinsic value and not having the stock called away, there's generally a trade-off between the amount of premium available and the time left until expiration because very short-term options will have less premium as well as a lower probability of being assigned, all else equal. To seek the right balance, some covered call investors will focus on options that expire in 20 to 50 days.

While time is measured based on the number of days on the calendar until expiration, implied volatility (IV) is computed using an options-pricing model as an annualized percentage. Each underlying stock and even each option can have a unique level of IV, which can change frequently.

For example, in the bottom half of the stock chart below, as the stock trends lower, IV moves higher, and as the stock rallies, IV moves lower. This inverse relationship isn't unusual but doesn't always happen either. Sometimes IV can increase along with the stock price, and other times, implied volatility can fall even as the stock moves lower, often after an anticipated company event like an earnings report, which happened in August on the chart below.

The key takeaway is that—all else equal—investors can generate more income from covered calls when IV is high. If, for instance, a stock has made a sharp fall and the investor wants to take a position in shares, the time might be ripe for a covered call if IV has seen a big jump. But, if a major rebound is expected, then buying the stock and not writing the call might be more beneficial to allow for additional upside in the share price. Ultimately, the trade-off is the premium received verses the opportunity cost of not owning shares if the stock sees a big rally.

The options greek delta is another handy indicator to consider when sizing up options for a covered call. Like IV, delta is computed using an options-pricing model, and it measures how changes in price, time (theta), and volatility (vega) might affect the value of an option.

An at-the-money (ATM) call option typically has delta of around .50. Out-of-the-money (OTM) call options have delta less than .50, and in-the-money (ITM) call options have delta greater than .50. The underlying stock has a delta of 1; puts have negative deltas. The following thinkorswim option chain shows how the delta of various call options increases as the strike price decreases. The shaded strike prices from 185 to 205 are ITM.

Many traders use delta as a rough estimate for the option expiring ITM. For example, a call option with .75 delta has roughly 75% probability of expiring ITM and a 25% probability of expiring OTM. If the goal of the covered call is to capture the entire extrinsic value by seeing the option expire worthless, some investors may focus on calls with deltas between .30 and .40 because there's a 60% to 70% theoretical probability they'll expire OTM. 

If the goal of the covered call holder is to sell the stock at a given strike price, then they might prefer to sell an option with higher delta and a greater probability of being assigned. However, it rarely makes sense to sell a call with very high delta—like an ITM option approaching a 1 delta—because it'll have little or no extrinsic value. An option with .60 or .70 delta, for example, might have the right balance that includes a higher probability of assignment and enough extrinsic or time value to make the covered call worthwhile.

Opening a covered call is just the first step in the process. It's also important to know what to do as expiration approaches. If the goal is to exit the stock via assignment on the call option and the call is assigned, there's nothing to do. The stock will be called away and the option ceases to exist. A call option on a stock or ETF can be assigned at any time, but the probability increases if the option is ITM (with little or no extrinsic value) at or near expiration.

If the call is OTM and the hope is to sell the stock via assignment on a short call, the investor can continue to hold the stock and roll the option, meaning closing the current position and opening another call with a lower or equal strike in a later expiration. The term rolling refers to the simultaneous closing of one option and opening another, providing more time for the stock to potentially be called away in a covered call.

The investor might also sell the stock outright after the call expires. Selling the stock before the call expires will result in a naked call options position, which changes the nature and risks of the trade and is only permitted in options accounts approved for this type of strategy.

Selling a covered call obligates the investor to sell the stock at the strike price, with no notice, at any time up to the expiration. If an investor is selling calls to generate income, doesn't want to exit the stock, and still holds the position as expiration is approaching (a week to 10 days away), then the next course of action will likely depend on whether the option is ITM or OTM:

• If the option is ITM near expiration, the call is at greater risk of assignment.
  • If assignment hasn't happened yet, it's typically possible to buy (to close) the call and hold the stock, which likely means taking a loss on the option part of the covered call.
  • Rolling the call to a later expiration and higher strike price can keep the covered call going.
• If the option is OTM near expiration:
  • Closing the call option (buying to close) can potentially lock in profits on the options portion of the covered call.
  • Allowing the option to expire worthless is the only way to keep the full premium; selling calls in a later expiration after the calls expire will roll the position if the outlook hasn't changed. In other words, an investor can open a new position after the expiration by selling a call in a later expiration.
  • Another way to roll is to buy the call back (to close) and sell (to open) an option in a later expiration as one spread trade.

If consistently trading covered calls, it can make sense to benchmark results against an index like the Cboe S&P 500 BuyWrite Index^(SM) (BXM). The index gets its name because some traders use the term "buy write" for the covered call; the strategy involves buying stock and writing (or selling) call options.

Launched in 2002 in a joint effort by the Cboe and Standard & Poor's, the index was created using historical data going back to 1986. The specific strategy involves holding a portfolio of S&P 500^® index (SPX) stocks and selling slightly OTM SPX call options with roughly one month remaining until expiration. New calls are sold on the third Friday of every month.

The BXM can serve as a useful barometer for the performance of the covered call strategy, similar to a portfolio manager benchmarking their strategy against the SPX. Cboe noted a few other interesting stats about the strategy's performance using BXM as a benchmark:

• From 1986 through 2023, BXM had volatility that was almost 30% lower than the SPX, as measured by its standard deviation.
• During that time, the worst decline in BXM was 35.8% compared to 51% for the SPX.
• The annual return since 1986 was 8.2% compared to 10.5% for the SPX.

The main reason the covered call strategy typically doesn't keep up with a simple buy-and-hold approach during rising markets is assignment of the calls caps the upside for the shares. Here are a few final points and common pitfalls to keep in mind:

• While high IV can be an opportunity to sell premium, it can also be a sign that an upcoming event like an earnings report could move the stock one way or the other. The covered call trader, on the other hand, typically wants the stock to see a gradual trend instead. Therefore, it makes sense to check the company's corporate calendar as well as any recent news on the company before chasing high IV.
• Some stocks have more actively traded options than others, and there can be substantial differences in spreads between the bids and asks in the options market. Many traders tend to look for spreads that are 10% or less of the ask price. For example, if the bid is $0.90 and the ask is $0.95, the spread is $0.05 and roughly 6% of the ask price. More liquid markets can make it easier to get in and out of stock and options positions at the desired prices.
• By default, when entering an order to buy or sell an option, it goes to the market as a day order and will cancel if it isn't executed by the end of that trading day. However, if a covered call owner has strategically selected an expiration, a strike price, and a price they want to sell the option, a good-till-canceled (GTC) order will give more time for the order to be executed; it'll remain active until the call is either sold or the order is canceled. At Schwab, GTC orders expire up to 180 calendar days from the date the order was submitted (unless filled or canceled).
• Some platforms allow investors to enter the covered call as one order at one price rather than buying the stock and selling the call separately. For example, on the thinkorswim option chain, right-click the bid or ask price of the call option to be sold, select BUY, and then choose Covered Stock from the list of strategies available to open an order ticket and buy the stock and sell the call as one transaction.

The typical goal in selling calls against stock positions is to generate income. The trade-off is that shares can get called away, which caps upside potential to owning the stock. For that reason, the covered call strategy only makes sense when an investor is willing to sell the underlying stock at a given strike price and is willing to accept this strategy can typically lag a buy-and-hold approach in rising markets. Appreciating both the pros and cons and understanding more advanced concepts like implied volatility, extrinsic value, delta, liquidity, and order types can help when selecting expirations and strike prices—doing so will help avoid some common pitfalls when using covered calls.