How To Generate Monthly Income With Covered Calls
Welcome to the detailed guide on Covered Calls for retirement accounts. This is one of the most trusted and widely used options strategies for long-term investors, and for good reason. It’s simple to understand, relatively low-risk, and perfectly suited for generating consistent income within a retirement account like an IRA.
If you own at least 100 shares of a stock you plan to hold for the long term, this strategy can transform that holding from a passive investment into an active source of cash flow.
Think of it this way: You own a rental property. The Covered Call strategy is like signing a lease agreement with a tenant. You collect rent (the option premium) upfront, and in exchange, you agree that you might have to sell your property (your stock) at a specific price if the tenant decides to buy.
Who Is This Strategy For?
The Covered Call is ideal for an investor who:
- Owns at least 100 shares of a stable, established company.
- Has a neutral to slightly bullish long-term outlook on that company.
- Wants to generate additional income from their portfolio beyond just dividends.
- Is willing to sell their shares at a predetermined, profitable price.
This strategy is not for someone who believes their stock is about to experience explosive growth, as the primary trade-off of a covered call is capping your potential upside.
Step 1: Choosing the Right Ingredients for Success
The success of a covered call strategy depends almost entirely on the quality of the underlying stock you choose. How to choose the best stocks for covered calls for income.
What Makes a Good Covered Call Stock?
- You Already Own It (and Like It): The golden rule is to only sell covered calls on high-quality stocks you are comfortable owning for the long term. This is an income strategy, not a speculative trade.
- Stability and Low Volatility: Focus on blue-chip, established companies. You want stocks that are less likely to make huge, unexpected price jumps. Think more Johnson & Johnson (JNJ) and less of a volatile tech startup.
- High Liquidity: The stock and its options should trade with high daily volume. This ensures you can easily enter and exit your trades at fair prices with minimal transaction costs (a tight bid-ask spread).
- Dividend-Paying (A Nice Bonus): Choosing stocks that also pay a dividend adds another layer of income to your total return.
Step 2: Selling Your First Covered Call – A Walk-Through
Let’s continue with covered call writing for beginners’, step by step.
Let’s walk through the process. Imagine you own 100 shares of a company, “Blue Chip Inc.” (BCI), which is currently trading at $98 per share.
- Log in and Find the Option Chain: In your brokerage account, go to your 100 shares of BCI and look for the “Trade Options” or “Option Chain” link. This will bring up a table of all available options for BCI.
- Choose an Expiration Date: You’ll see a list of dates. For generating regular income, it’s common to select an expiration date that is 30 to 45 days away. This period offers the best balance of premium income and time decay (which is the profit engine for an option seller). Another popular strategy is to sell weekly expirations (if that particular stock offers weekly’s). This will take a little more managing but it can possibly offer a higher return on your investment, as collecting 4 weekly premiums usually is higher than collecting one monthly premium.
- Choose a Strike Price: The strike price is the price per share you agree to sell your stock for. This is the most important decision you’ll make.
- Let’s say you choose the $100 strike price. This is an “out-of-the-money” (OTM) call because it’s above the current $98 stock price. Selling OTM calls is the standard approach for income generation.
- You look at the premium for the $100 call and see that it’s trading for $2.00.
- Place the Order: You will place a “Sell to Open” order for 1 contract of the BCI $100 strike price call option.
- Collect the Premium: Once the order is filled, your brokerage account is immediately credited with $200 ($2.00 premium x 100 shares). This money is yours to keep, no matter what happens next. In exchange, your 100 shares of BCI are now “covered,” meaning they are held as collateral for the potential obligation to sell them for $100 each.
Step 3: Understanding the Possible Outcomes at Expiration
Fast forward 30 days to the expiration date. One of three things will have happened.
Outcome #1: The Best-Case Scenario
The stock price of BCI is below the $100 strike price (e.g., it’s at $99).
- The call option expires worthless.
- Your obligation to sell the shares disappears.
- Result: You keep your 100 shares of BCI, and you keep the full $200 premium as pure profit. You are now free to sell another covered call for the next month (or week).
Outcome #2: The “Successful Sale” Scenario
The stock price of BCI is above the $100 strike price (e.g., it’s at $105).
- The call option is “in-the-money” and will be assigned. Your broker will automatically sell your 100 shares for the agreed-upon $100 per share.
- Result: You sold your shares for $100 each (a $2 per share capital gain from your starting price of $98) AND you keep the $200 premium. Your total profit is $400 ($200 from the stock gain + $200 from the premium). This should not be seen as a loss, but as the successful execution of your plan to sell the stock at a profitable price.
Outcome #3: The “Downside Cushion” Scenario
The stock price of BCI has fallen (e.g., it’s at $95).
- The call option expires worthless.
- You keep your 100 shares of BCI, and you keep the full $200 premium.
- Result: Your stock holding has an unrealized loss of $300 (from $98 down to $95). However, the $200 premium you collected helps to cushion that loss. Your net unrealized loss is only $100, not $300. The income from the call provides a small amount of downside protection. Now for full disclosure that loss, from $98 to $95 is called an unrealized loss, because unless you then sell the stock you don’t lose the cash, just the net value of your account. If you hold until it goes back up you could still make a profit on the trade.
Step 4: Managing Your Position (You Have Choices)
While you can simply let every option expire, you also have the flexibility to manage the position before the expiration date.
- Closing the Position Early: Let’s say after two weeks, the price of the call option you sold for $2.00 has decayed down to $0.50. You can place a “Buy to Close” order to buy the contract back. This would cost you $50, locking in a $150 profit ($200 received – $50 paid) and freeing up your shares immediately. Many traders do this to realize profits early and reduce risk.
- “Rolling” to Avoid Assignment: If the stock price rises to $100 and you decide you don’t want to sell your shares, you can “roll” the position. This is a single trade where you buy to close your current $100 call and simultaneously sell to open a new call with a later expiration date and a higher strike price (e.g., the $105 strike). Often, this can be done for a net credit, meaning you collect even more premium and give your stock more room to run.
The Risks You Must Understand
- Opportunity Cost: This is the biggest risk. If BCI stock unexpectedly soars to $120, you are still obligated to sell your shares for $100. You would miss out on that extra $20 per share of upside. You trade away large potential gains for a smaller, more certain profit.
- Significant Downside Risk: A covered call offers only limited protection if the stock price plummets. If the stock falls by $10, your $2 premium will do little to offset that loss. The risk profile is very similar to simply owning the stock.
Congratulations! You now have a complete picture of how to use the Covered Call strategy to safely and effectively generate income in your retirement account.