Cover Your Bases: How to Use Covered Calls To Generate Passive Income

Cover Your Bases: How to Use Covered Calls To Generate Passive Income

Covered calls can help you juice your passive stock positions for more returns. Here’s how you can make them work for you.

Cover Your Bases: How to Use Covered Calls To Generate Passive Income
Noah Weidner

Updated Nov 11, 2022

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Stock Trading

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Passive Income

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  • Covered call options are one of the most popular options strategies for those with abundant capital
  • The poor man’s covered call is a way to take advantage of covered call strategies with less capital upfront
  • Options are not recommended for amateur traders. There are ETFs that can do the grunt work for newer investors.

 

Every day, trillions of dollars change hands in global markets. Most of it sloshes around in the bond market, some of it gets sprinkled into stocks, and a smaller portion ends up in the wild world of options.

You’ve probably heard of options before if you’ve been around the trading block. Options are a way investors can bet on or hedge against assets like stocks. And if you're part of the new generation of investors, you may get an unsavory taste in your mouth when options get brought up.
 

Though the poor man’s covered call has its allure, you might find that the juice is simply not worth the squeeze (or risk).

That’s because many unseasoned investors have tried their hands trading these relatively complex instruments—and failed. An April 2022 study shows that retail investors generally lose when they put their money into options. The main reason? Many retail investors treat the options market for stocks like a casino, with forums like r/WallStreetBets as the highlight reel of the most degenerate losses and glorious gambling wins.

But if you attack options trading responsibly, there’s definitely money waiting at the end of the proverbial rainbow. In this article, we’ll attack one of the most common and effective options strategies to generate income from your stocks known among traders as the poor mans covered call. However, before we dive in, here’s what the unacquainted must know about options trading.

What are options and how do they work?

Before we delve into how you can use the poor man’s covered call to generate some passive income, it might help to understand the basics of trading options.

As we’ve already noted, the options market is a place where investors can bet on or hedge against assets like stocks. Options are a derivative, which means its value as an asset is affected by another asset. Futures and options are both derivatives of other assets.

Sophisticated traders can use options contracts to bet that the price of something will go up, go down, stay about the same, or act volatile. They do this by using four main kinds of options: 

  • buying calls
  • buying puts 
  • selling calls
  • selling puts

Individually, buying calls and selling puts are considered bullish, while buying puts and selling calls are considered bearish.

There are two other components that are crucial when it comes to options trading: the strike price, which is the price you expect the stock to be at, above, or below by a given date; and the expiration date—the day your prediction is put to the coals.

Now that you have an elementary understanding of how options work, let’s take a look at how covered calls work.

What’s a covered call?

Before we jump to the slightly more complicated poor man’s covered call, let’s start with the basic covered call.

In short, a covered call is a popular strategy which relies on both holding stock and options.

For example, let’s say you have 100 shares of Boeing Co (BA) stock and you expect to sit on it for a while. By owning those shares, you’re exposed to both the upside and downside of the company’s stock price. 

However, there’s an alternative: selling Boeing options contracts. Specifically, selling a call—which allows you to become neutral on the stock in the near term and make money in the process. This is not without risk, but by selling a call against your Boeing stock, you have insurance in case your bet goes awry and you’re sold option is exercised.

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Selling a call option gives the option seller a premium for the risk of entering into a bet. 
Source: nerdwallet.com

But before we do that, it might be worth understanding what a normal covered call looks like.

How a covered call works

Holding 100 shares in Boeing is a long, bullish position. By owning them, you're probably confident the stock will rise over time. However, selling a call by itself is a bearish position—and since each option represents 100 shares, selling that call means you lose 100 shares of exposure, meaning you have no exposure to the stock price.

You collect a premium by agreeing to sell a call, which means you’re basically entering into a bet that the value of a stock will stay at or below the strike price you’re selling at. The premium is a fixed amount of money you collect for entering into the bet—and if you’re right, you get to keep the premium.

For example, say Boeing stock is $150 per share. You’d choose to sell a call at a strike price close to the price the stock is trading at. For many popular stocks, you can look at the options chain or options ladder to sell premium at $160 or $170 to avoid trouble. You’d pocket more premium for additional risk, which is selling the option closer to the current price. 

What are the risks of a covered call?

Selling a call has its risks. In order to even open an options position, you will need the liquidity in your account to pay if you’re wrong. If you are wrong and the stock price goes higher, then the price of the call you sold will take a bite out of your profit. That’s because selling a call is tantamount to a short position.

In the worst case scenario, you might be exercised, which would require you to deliver the shares. This would happen if the trader who bought the option from you is in the money, meaning their option is at or below the price they’re betting on. This would mean that they want to buy the underlying stock, and as part of your contract, you’re required to deliver 100 shares of the underlying stock.

You might say that these risks aren’t worth it for the premium you’ll collect. However, many experienced investors use options as a hedge for their portfolio sizing and planning.

What’s a poor man’s covered call?

One of the shortcomings of the covered call option is the need for liquidity. 100 shares of a company like Boeing, Apple, or Meta will set you back thousands of dollars—but if we apply some of the findings of the standard covered call, you can use a few key differences to make cash.

Essentially, a poor man’s covered call is a cheaper way to execute a covered call using just options. It’s best for those who have limited liquidity, because selling premium is often considerably cheaper than buying stock. However, the poor man’s covered call is more risky because it requires you to buy a call option and sell a call option.

What does that look like? Here's an example.

How a poor man’s covered call works

With traditional covered calls, you'd have to own 100 shares of a stock before selling an option. That’s because, if you don't, you'd be carrying a position without insurance—the capital necessary to sell if you're exercised or your bet is wrong.

However, as you might have gleaned from the last example, you could always use options to balance your trade. In a poor man’s covered call, you buy a call option with a longer expiration cycle, then sell an out-of-the-money call option with an expiration date closer to the present.

This position is called a spread. The resulting spread would leave you with zero shares of net exposure for a short period of time.

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A poor man’s covered call requires you to buy a call option that's deep in the money, then sell a near-dated call option.

Source: https://www.tastytrade.com.

Buying an in the money (ITM) call means purchasing a call which is already a correct bet. For example, say we look back at the Boeing example—if the stock price is $150, an in the money call option would be worth $150 or less—so you could purchase with a strike price of $140. Assuming the stock stays above the price you acquired it at, you shouldn’t lose any money.

On the flip, selling your out of the money (OTM) call option is also a correct bet in this example. Let’s assume Boeing’s stock price is $150. If you sell an OTM call option at a price like $160, you’ll pocket the premium from making that bet. Assuming the stock doesn’t rise adversely, you shouldn’t lose any money.

Unlike in the case of the traditional covered call, the combination of buying and selling calls means you’re making a bullish bet. Meaning that, if you’re entering a poor man’s covered call option, you’re betting that the stock will actually go up in the future. That’s because you’re exercising premium, but you also have long exposure to the underlying stock price.

That means you hope the OTM call you sold reaches its near term expiration date, then the ITM call you bought keeps rising.

The risks of a poor man's covered call

In the traditional covered call position, owning 100 shares of the underlying stock is like a form of insurance on your short call. Assuming your bet goes wrong or you get exercised, you could sell the 100 shares to pay for your traditional covered call.

In a poor man’s covered call, buying a longer dated call option serves the same purpose as the 100 shares—it’s your insurance, or hedge, in this strategy. In the case the OTM call you sold is exercised or ends up in the money, you would exercise the call you bought to cover the loss.

Of course, the same risks that apply to the traditional covered call will also apply to the poor man’s covered call. You run the risk of making a bad bet or your sold call being excercised, just like in the traditional covered call. The only difference is that the poor man’s covered call requires less capital upfront, so it's effectively a cheaper position to enter if you're brokerage account is strapped for cash.

Where can I trade options?

You can trade options on any brokerage that supports options trading. Platforms such as TradeStationRobinhood, and WeBull are just a few of the popular options that traders use to trade options. In our review of TradeStation, we found that it's a great platform for daytraders, but Robinhood or WeBull might be better suited for beginners.

tradestation
TradeStation

Stocks

What’s an alternative to covered calls?

Selling covered calls is not hard work, but it’s not easy, either—though the poor man’s covered call has its allure, you might find that the juice is simply not worth the squeeze (or risk).

That’s one reason why some amateur investors simply choose to invest in covered call ETFs. These lesser-known ETFs handle the busywork of selling calls and holding the stock necessary to back it. They then return the premiums to you in a dividend.

The Global X Nasdaq-100 Covered Call ETF (QYLD) is the largest covered call ETF by assets under management (AUM). You buy the ETF to gain exposure to stocks and short calls in the Nasdaq-100. It has a high expense ratio—0.60% is 20x higher than the Vanguard S&P 500 ETF—but has paid a roughly 17% dividend in the trailing 12 months.

Global X also owns the other two largest covered call ETFs, which invest in S&P 500 and Russell 2000 companies and their underlying options. Other covered call ETFs owned by companies do exist, but they do not command as much AUM.

The most important thing to know when buying these ETFs is that the stock price of the underlying ETF will generally move with the market, but it won’t match it. Additionally, you’ll probably want to know that these ETF strategies are capped to the upside. In other words, you want stocks to trade equal or below the price the ETF's are at so that the short call option expires out of the money.

You can buy these ETFs on brokerage apps which support them such as Robinhood or TradeStation.

Many investors will find buying covered call ETFs more preferable than using a traditional covered call or poor man’s covered call strategy. However, for investors wanting to be hands on, they all have merit.

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