Covered Call Options
When I first discovered covered calls, I thought
they were the greatest investment tool ever created.
That was until I got burned by doing them the
wrong way. I still use covered calls in my trading
but with better rules and only in the most optimal
situations.
What Is a Covered Call?
There are two parts to the covered call strategy.
One is stock and the other is a short call. This
option trade is used to increase the yield on
the stock by selling an out of the money call
on stock that you already own.
A Covered Call Trading Example
Let's say you own 100 shares of IBM. The current
price is $100. Since IBM is such a large company
with millions of shares outstanding the price
of the stock does not move around much. Let's
also assume that you think the price of the stock
is going to stay around $100 for the next 30 days.
If the price just sits there, you are not going
to make any money. But you can if you write a
covered call.
You decide to sell a 110 strike call option that
will expire in 30 days. By writing this call,
you get paid $2.00 per share or $200 total. This
means that if IBM is below $110 on expiration
day, the option will expire worthless and you
get to keep the whole $200. You keep the stock
too.
If IBM is above $110 at expiration, you will
have to sell your 100 shares for $110 a share.
But you get to keep the $2.00 per share you got
paid for the option. So actually you get to sell
your stock at $112.
In my opinion the best case is if IBM is at $109.90
at expiration, the call option expires worthless,
the stock is up $9.90, you got $2 for the call,
and you still own the stock giving you the ability
to sell another call the next month at a higher
strike for more money.
Technically you make the highest percentage return
when the stock is sold for you by the broker at
$110 (this is called having the stock called away),
but I would rather keep the stock and sell another
call the next month.
If you own stock that you are going to keep for
years and not sell under any circumstances, selling
covered calls against it is a great strategy.
If you are looking to write covered calls as an
income strategy, it is not the best option you
have. There are other option selling strategies
that are safer and can make a much higher return
for the same amount of capital. These strategies
are covered on other pages of this website.
If you sign up for my FREE Option Selling
Course I will show you some examples of Butterflies
and Iron Condor trades I did with real money and
how I adjusted them to stay out of trouble. To
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The Profit Potential of Covered
Call Writing
The more volatile the stock the more expensive
the calls are and so your percentage return can
be great. Apple is a much more volatile stock
than IBM so even if their stocks were at the same
price, Apple options would cost more than options
in IBM.
The Dark Side of the Covered
Call
At first I did not see any flaws in the covered
call strategy. I would buy some stock and sell
a call against it. If the stock went up, I could
either let the stock get called away or I could
buy back the sold call and sell another one at
a higher strike price the next month out. I thought
I could just sell options month after month. If
the stock went down, no problem. I would keep
selling calls month after month until I collected
enough money selling the calls to pay for the
stock. That is what I wanted - I wanted free stock
that was paid for by selling calls.
But there were a few things I did not consider.
A sharp decline in the stock would cause me to
lose a lot of money, and perhaps cause a margin
call. Even without the margin call I underestimated
the amount of pain I could stand. Here's a real
life example. There was a stock that I bought
several hundred shares of with the sole purpose
to sell covered calls. I did not want to own the
stock long term. I wanted to be out within a month.
The only problem was the stock dropped - big.
It went from $17 to $12. The calls I had sold
expired worthless. But they did not make up for
the loss. So I decided to sell more calls. This
time I sold them at a lower strike. The stock
dropped more. And kept dropping until the low
point at about $2. By then I had sold half my
shares and kept the rest hoping and praying it
would eventually recover
That is the dark side of the covered call. The
trader has no protection on the downside. Selling
the call actually makes it more complicated because
if you just owned the stock you can just sell
it. But if you have a call you then have to buy
the call back, or keep the call and hope it expires.
If the stock rebounds you could get hurt because
now you have a naked call position but no stock
to deliver.
That's why covered call strategies are
best used on safe, solid companies that have been
around and will be around.
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Covered Calls Without Stock
One big problem with the covered call strategy
is the need for a lot of capital. You have to
own the stock. That ties up a lot of money as
well as putting it at risk.
An alternative is to use a long call instead
of stock. To do this you would buy a deep in the
money call option with several months to expiration.
And then sell calls against it closer to expiration.
This is called a synthetic covered call.
Since the long call costs less money than the
stock, not only will you have less money in the
trade, but your potential return on investment
is much higher as well.
Covered Call Summary
Covered Calls are a good option trading income
strategy. They work most of the time. And since
only one option is involved they are a good introduction
to option selling. But beware the downside. Covered
Calls are to be used in sideways or up markets
only. There are ways to protect yourself from
loss, but I find that the low return from covered
calls compared to other strategies make them less
attractive to full time traders.
I myself am always looking for the safest trade,
which can make the most money, without me having
to do much work. I started with covered calls
and then upgraded to other strategies. I still
do them on occasion on stocks I own in my retirement
accounts. But I do not think they should be the
only strategy in a trader's tool belt.
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