How to Trade Covered Calls
Covered calls are one of the oldest in the options playbook and great for share holders 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. Watch our video on how to trade covered calls.
What Are Covered Calls & How Do They Work?
Writing covered calls just means you’re selling someone else the right to purchase a stock that you already own, at a specific price, within a specified time frame. As an owner of securities, you have several rights. One of them 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 is employed known as writing covered calls.
Now that I have your attention let’s take a look at this conservative, yet effective approach. As a result, you can learn how to make some extra money. Who doesn’t want that?
Do covered calls differ from a call option? These are the little details that can cause some confusion to new traders. In fact, options have more moving parts than a stock does.
That, in and of itself, can cause confusion starting out. Therefore, starting out 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 date of expiration.
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How to Write Covered Calls
In order to make money, you can “write” or “sell” options on that asset. 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 simply pocket the premium paid, in cash, on the day the option contract is sold. What’s more, you get to keep the buyers money; even if they don’t exercise the option.
What’s important to remember is that a call is considered covered if the seller actually owns the underlying security. In other words, the seller is covering their butt.
This is because if the buyer decides to exercise the option they bought from you, you need to 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.
By selling an options contract on your underlying security, you effectively forfeit your ability to control your stocks. Which means if the individual stock price soars and moves above the options strike price you can’t sell for a profit.
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’re legally obligated to provide the buyer those 100 shares for the agreed upon strike price. Furthermore, they can sell the shares on the open market. In fact, if the price soars they receive a nice tidy sum.
Is a Covered Call Bullish or Bearish?
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. Essentially a covered call acts as a short-term hedge on your long-term stock position.
Because they feel the stock won’t dramatically go up in price in the short term, they simply write a call option to make money from the option premium.
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When You Shouldn’t Write Covered Calls
Selling options contracts is not very useful for very bullish or bearish investors. In fact, it would make better sense just to hold the stock and simply sell it for a profit if the stock price spikes.
Similarly, if you’re bearish, it might make better sense to sell the stock. 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.
Stock training is important in order to understand when to buy and sell options.
Calculating Your Maximum Profit and Loss
In order to calculate the maximum amount of money you would make from selling a call option is the strike price minus the purchase price of the underlying security, plus the premium received.
On the contrary, your maximum loss is equal to the purchase price of the underlying security less the premium received.
Different from covered calls, selling naked call options without actually owning the underlying security is extremely risky. This is because they have theoretically unlimited loss potential if the underlying security rises.
A Real Life Example
Angela owns shares of the hypothetical company Bali Beds (BB). She really likes the long-term outlook of the company, the potential growth and the affordable share price of $25.
It’s a different story however for the short term. She feels the stock might trade sideways for a while and only fluctuate a few dollars give or take from the current $25 price.
In order to make money, Angela can write and sell a call option on BB with a strike price of $27. 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.
Which means she still owns the stock and has an extra $75 in her pocket, less fees. In this case, the buy-write strategy has successfully outperformed the stock.
Obviously, 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 to offset the decline in stock price. All in all, there’s really no bad news in this scenario.
Scenario 3: The Stock Price Rises Above The Strike Price
BB 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. In fact, her risk was limited since it was a covered call. Hence the importance of understanding covered calls and all they entail.
- 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
What Happens When a Covered Call Expires?
If a call contract is assigned then the stock is sold the contracted strike price of the call. If a covered call is assigned then the stock that’s owned is then sold.
Wrapping It Up
In short, writing covered calls in not that risky. You already own the stock so really, the primary risk is the loss of value in your stock.
The reality is, the sale of the option only limits your opportunity to the upside if the price skyrockets. As a result, as long as 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, in theory, 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. Be sure to take our options strategies course.
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.