Covered calls are one of the oldest in the options playbook and are great for shareholders to make some extra income on the shares they are planning to hold onto for the long haul. This is a strategy used to generate income in the form of premiums. The trader selling the call owns the same amount of shares of the underlying stock. So, they write (sell) a call on the same stock and collect a premium.
Table of Contents
- What Are Covered Calls?
- Real Life Example of Covered Calls
- Buy Write Covered Break Down
- Frequently Asked Questions
What Are Covered Calls?
Writing covered calls means you’re selling someone else the right to purchase a stock you already own at a specific price within a specified time frame. As an owner of securities, you have several rights. One includes the right to sell the security at any time for the current market price.
Professional investors and traders in the options arena have a handy tool in their toolbox to increase their portfolio income. And no, it’s not some fancy safe-cracking device, although that would be cool. However, a simple yet effective strategy, known as writing covered calls, is employed.
That, in and of itself, can confuse starting. Therefore, starting with the basics is necessary. However, options trading allows you to make money in any market.
Hence, writing covered calls. Let’s begin with understanding what a call is.
In a nutshell, a call option is a contract that allows the buyer the right but not the obligation to buy 100 shares of the underlying stock or a futures contract at a certain strike price any time on or before the expiration date.
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Covered Calls Basics
What’s important to remember is that a call is covered if the seller owns the underlying security. In other words, the seller is covering their butt.
If the buyer decides to exercise the option they bought from you, you must deliver the security to them. By already owning it, you’re not at the whim of the open market.
Where, quite possibly, you may have to buy the shares at an unfavorable price. Doing that can and will hurt you more than help. That’s not the goal. Your goal is to make money, not lose it.
Covered Calls Downside
By selling an options contract on your underlying security, you effectively forfeit your ability to control your stocks. This means you can’t sell for a profit if the individual stock price soars and moves above the options strike price.
In this situation, the person who profits is the one who bought your option contract. They may do so as they can then choose to exercise the option.
Unfortunately, you must provide the buyer with those 100 shares for the agreed-upon strike price. Furthermore, they can sell the shares on the open market. If the price soars, they receive a nice tidy sum.
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Writing Covered Calls
Similarly, if you’re bearish, selling the stock might make better sense. The reason for this is the premium received for the call option might do little to offset the loss on the stock if the price plummets.
Calculating Your Maximum P&L
To calculate the maximum amount of money you would make from selling a call option, the strike price minus the purchase price of the underlying security plus the premium received.
On the contrary, your maximum loss equals the purchase price of the underlying security minus the premium received.
Unlike covered calls, selling naked call options without owning the underlying security is extremely risky. This is because they have theoretically unlimited loss potential if the underlying security rises.
Real Life Example of Covered Calls
Angela can write and sell a call option on BB with a strike price of $27 to make money. As a result, based on the premium she receives for the 3-month call option at, let’s say, $0.75/share ($75 per contract or 100 shares), one of three scenarios will result:
Scenario 1: The Stock Goes Down
BB will trade below the strike price of \$27. If this happens, the option will expire worthless. And the good news is Angela keeps the premium paid for the option.
The bad news is the stock is down in value, but she’s in it for the long term. As a result, in the long term, it should turn around with time.
Scenario 2: The Stock Fluctuates A Little In Price But Doesn’t Reach The Strike Price
BB share price falls, and the call option you wrote expires worthless. Once again, Angela keeps the premium paid, which helps offset the stock price decline. All in all, there’s no bad news in this scenario.
Scenario 3: The Stock Price Rises Above The Strike Price
BB’s share price goes above $27. As a result, the buyer exercises the call option, and she has to sell 100 shares of the stock. Luckily for Angela, the upside has a cap of $27.
She might kick herself for missing out on the additional gains, especially if the price skyrockets. However, there’s no need for that.
It was an informed decision to part with the stock. Her risk was limited since it was a covered call. Hence, it is important to understand covered calls and all they entail.
Buy Write Covered Call
Have you ever heard of a buy-write-covered call? If you have big trade plans but limited working capital, listen up. Options are a great way to maximize leverage while minimizing risk. In this article, we will discuss a strategy known as the Poor Mans Covered Call, or PMCC, for short.
The buy write covered call position is considered a synthetic position. Why? Because you’re using your opinion to buy 100 shares of stock as leverage to sell covered calls.
One benefit is that you only need a fraction of the capital required to buy 100 shares of stock in selling each traditional covered call.
The strategy is to buy an in-the-money call with an expiration of at least six months or more. And sell a covered out-of-the-money call with an expiration date that’s a month or less out against it. Pretty easy, right? But you must know a few things about the buy-write vs. covered call to make the trade profitable.
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What’s the Objective?
The objective is to take advantage of time decay on the short call. However, it can take a week or more to realize any profit. This doesn’t work on penny stocks. The ideal equity will have a share price of about $40 or more.
On the bright side, you will have control of \$4,000 or more worth of stock while only having to lay out a few hundred dollars or more. The position can move against you. But you’ll have plenty of time to react. Time decay and price degradation of the short call will give you a lot of cushion if the trade goes against you.
One thing you can do is buy the short call back for less than you sold it for. Then sell it again later for more than you bought it for. Remember you have time on your long call.
Paying attention to the break-even price of your long and short calls is very important. Your profit margin is the difference between them. The break-even price on your short call must always be greater than that on your long call. This way, if you are assigned, you are guaranteed profit.
“Time Is Money”
My take on the phrase is “More Time is More Money.” I like LEAPS. But I like them more when they are free. The more time you have on your long calls, the more time decay you can take advantage of on your short calls.
Time decay on a LEAP is very minimal. And time decay on monthly options is brutal. In terms of the “Theta Gang,” this would make you a “Theta Kingpin. The strategy is to buy to open (BTO) an in-the-money (ITM) call with an expiration date a year or more out. I prefer deep in the money (DITM) with my long call that’s a year out.
But I like to start with a call that’s two years out or more, depending on Delta. Sometimes, an extra year is not too much more premium outlay. Once you have established your long position, start selling premiums. The typical PMCC is a simple diagonal calendar spread to close the position when profitable.
But by now, you know that I love to reduce my cost base by almost literally renting out my long position on a month-to-month basis.
Buy Write Covered Break Down
The buy write vs covered call method to my madness is a little complex, but I’m happy to break it down for you. There are some equities where you can have a diagonal spread only a few months wide and a few strikes vertical. These short-term PMCCs are typically low-risk and low-reward but have a high probability of profit. However, if it starts to move against you, it leaves little chance of exiting with a profit. This is why I would rather have a long position that is years out.
What’s the Catch?
The catch is that you must make sure that you always know the break-even price of your long position. The idea is always to expect your covered call to be exercised. Differing between your break even and the break even on the covered call should always be a positive number.
For example, let’s say that I paid a $5.00 premium for a $40 strike call. My break-even price is $45 per share. To make a profit, I must only sell a covered call with a strike price with a break-even price above my break-even price.
The profit margin will initially be pretty small when selling monthly covered calls. But remember, you must manage your risk. It would be best to remember that for each monthly covered call that expires worthless or is bought to close (BTC) for less than you sold to open (STO), that profit would reduce your break-even price and, essentially, your cost basis.
After a few months without being assigned to your covered calls, your break-even will be significantly reduced, and your profit prospects will become more lucrative.
Daily price action works the same for almost every option strategy in my wheelhouse. Opening bell hours and power hours always have the highest implied volatility. You will want to focus on those times when selling your covered calls. You’ll likely want to buy your long calls in the middle of the day. But it’ll not have nearly as much effect on LEAPS.
This can be a very passive strategy, but I am anything but passive. You can buy and sell options repeatedly to take advantage of the daily price action. But be mindful that PDT rules still apply to options.
When traded passively, it can take more than a year to cover the cost of the long call that is two years out. When I trade the daily price action, I can usually cover the cost of my long calls in 7 to 11 months.
Do you want to know when to take profit? You can close this trade any time you want. But you’ll likely want to take profit on a much longer duration once you have closed a few short calls. Here is where you want to consider a few choices.
You can close your position and move on after a few months or hang it out within a few months of your long call expiration. At that point, you can either sell the long call and buy back your short one or exorcise your long one if you have the cash. You can also roll your long call out another two years and open the position again.
Simple Buy Write Covered Call
Start simple. Find an equity with a little volatility but an established long-term bullish trend. This would have been much easier before the pandemic; however, a lot of sector rotation is starting to take place. You primarily want to stick to slow and steady instead of rapid growth. The idea is that you want to keep your risk low and your reward steady but highly probable.
Over time, that reward will grow even if your chosen equity goes sideways for a year. Set a reasonable stop loss that allows a little more wiggle room than you would if you were swing trading. My stop loss for swing trading is just 4%, but my stop loss for the PMCC is 25%. That LEAP gives you lots of time to recover, and selling monthly covered calls will give you an edge to expedite recovery. Choose a reputable company to trade. Don’t try this on a fly-by-night Chinese electric car company.
Key Takeaways of Covered Calls
- A popular, lower-risk options strategy to generate income from premiums
- You must already own or hold a long position in the asset
- A great strategy when you want to hold your shares over the long term
- Use when you feel the share price won’t fluctuate much in the short term
- Every day the stock doesn’t move, the call you sold will decline in value
- Don’t utilize this strategy if you’re a bullish or a bearish investor
In short, you are writing covered calls, which is not risky. You already own the stock, so the primary risk is the loss of value in your stock.
In reality, the sale of the option only limits your opportunity to the upside if the price skyrockets. As a result, if the stock price doesn’t reach the strike price and the call option gets assigned to you, you won’t have to part with 100 shares.
Therefore, if you have a chunk of shares, why don’t you practice writing covered calls?
As you know, practice makes perfect, so the more you run, the better you get.
As a result, you can learn more about stocks and options. The more you know, the more strategies you can use to turn a profit.
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Frequently Asked Questions
You can “write” or “sell” options on that asset to make money. By doing this, the buyer of the option gets the right to own your security. As a result, they may exercise it on or before the expiration date at a predetermined strike price. You sell your right to your security to someone else. That person can then exercise the contract. As a result, you pocket the premium paid in cash on the day the option contract is sold. Moreover, you get to keep the buyer's money, even if they don’t exercise the option.
Covered calls are a neutral strategy used by investors who feel the stock price won't dramatically fluctuate for the duration of the call option. Typically, this strategy is used by investors who intend to hold their stocks over the long run. However, a long-term investor may want to make money in the short term. A covered call acts as a short-term hedge on your long-term stock position.
Because they feel the stock won't dramatically increase in price in the short term, they write a call option to make money from the premium option.
If a call contract is assigned, then the stock is sold at the contracted strike price of the call. If a covered call is assigned, the stock owned is sold.