Become a smart option trader by using our preferred covered call strategy. In this options trading guide, we’re going to cover what a covered call is, the bullish strategy of the covered call, and how selling covered calls works.
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Covered calls are a very common options trading strategy among long stock investors. This strategy allows you to collect a premium without adding any risk to your long stock position. Basically, covered call options is a very conservative cash-generating strategy.
The best stocks for covered call writing are stocks that are either slightly up or slightly down in the markets. If you want to generate additional income, you should implement the covered call strategy in combination with dividend stocks.
If used correctly, selling covered calls on dividend growth stocks can have a compounding effect on your stock portfolio.
Let’s get into it. First, we will examine what a covered call is and it's characteristics.
What is a Covered Call?
The covered call option is an investment strategy where an investor combines holding a buy position in a stock and at the same time, sells call options on the same stock to generate an additional income stream.
A covered call strategy combines two other strategies:
- Stock ownership, which everyone is familiar with.
- Option selling.
First, we're going to buy a stock for a debit. Then we’re going to sell an option for credit. The key difference is that an option is just a contract that gives you the right, but not the obligation, to buy or sell shares of a stock.
To better understand covered call writing, let’s take a look at the three words included in the strategy:
- Covered means we first buy the stock before we sell the option. This puts us in a protected position. Throughout this guide, we’re going to outline why it’s important to own the stock before selling call options.
- Call is the definition of the type of option that we’re selling. We’re selling the right, but not the obligation for, the option buyer to purchase our shares from us.
- Writing means that we’re selling the option, not buying it.
Let’s make it all come to life with a preview covered call example.
First, remember that we have to buy the stock before we sell the option. So, we’re going to buy 100 shares of ABC stock for $45 per share. That creates an investment of $4500.
One options contract consist of 100 shares of stock. So, if we’re going to sell 1 contract of call option, we must first own 100 shares of that stock. For 5 option contracts we need to own 500 shares.
Once we own the shares we then sell the call option. We’re going to decide on the price that we’re willing to sell it and the date that we’re willing to sell it. In this hypothetical example we agree to sell at $50 at any time over the next 1 month.
In other words, the $50 is our strike price, or the price we agree to sell our stock for. And the 1 month represents the expiration date. All options expire on the third Friday of the month.
In return for undertaking this obligation to sell our stock at a certain price by a certain date we’re going to receive or capture a premium. In this hypothetical covered call example, the average premium is $1 per share or $100 for 100 shares.
This translates into a 2% initial return (100 shares/$5000*100).
Now there are two possible outcomes:
- Stock price stays under $50.
- Stock price moves above $50.
Let’s take a look at each possible scenario!
If the stock price remains under $50, the option buyer will not exercise that option. The holder of that option doesn’t have any reason to buy the shares for $50 when they can buy them at market for less. In this case, we keep our shares plus the option premium (which we keep under all circumstances). Now we can sell another option the next month on the same shares.
Note* You can use a covered call calculator to help you know when to roll your call option.
In this particular case, a one moth return would be 2%.
Now, the other possible scenario is when the price of the stock moves above $50. In this case, the option buy will exercise the option, and buy it for $50. Thereby generating a profit if the price of the stock is above $50.
We then receive an additional $500 profit from the sale of the stock. Remember, we bought the stock at $45 and sold it at $50, and they were 100 shares. In this case, our total profit would be $100 from the sale of the option, plus another $500 from the sale of the stock, for a total of $600.
This represents 12% one-month return.
We’re not here to tell you that there is no risk involved in covered call trading strategies. Like with any trading activity, there is some level of risk. In the case of covered call stocks, the risk is low. The only way you will lose money is if the stock price declines by more than the premium collected.
In the above covered call example, we bough the stock for $45 and we generated $1 premium for each share. So our breakeven is $45 - $1 = $44.
We lose money only if the price of the stock gets below $44.
That’s the reason why stock selection and managing your position are so important to maximize your profits.
Covered Call Strategy
There is also a synthetic covered call strategy, which requires less capital. This can be an effective approach for option traders with less money. This strategy is a good one and traders refer to it as the poor man’s covered call.
In the option world, the poor man’s covered call is also a long call diagonal spread.
The covered call strategy is affected and at the same time also benefits from low volatility.
The poor man’s covered call is pretty much the same as the real covered call strategy. We have an in the money option that we buy, and we sell an out of the money option to reduce our cost basis on that long option.
So, the only difference is that instead of buying the stock, we replace it with an "in the money" call option. In the money options means the call option is below the stock price because a call contract gives you the right to buy at a certain strike price.
One interesting thing about these diagonal spreads is that they are simply a combination of a calendar spread and a vertical spread.
This options strategy requires following a three step process.
Step #1: Choose a Low Volatile Stock
Let’s take as an example, Starbucks a low-beta stock.
Remember we want a stock with low volatility.
Starbucks illustrates the typical low volatile stocks that we prefer implementing with the poor man’s covered call strategy.
If stock’s beta is 3, it indicates that the stock is three times more volatile than the market. If the market is forecasted to give a 10% return, your stock will then give you an amazing 30% return. But if the market slips 10% than the stock will give you a 30% loss which is very terrible.
As a trader your number one priority should always be capital protection. This is why we like using the poor man’s covered call strategy.
Step #2: Buy In the Money Call Option
If you were to buy 100 Starbucks shares you would be required to have a minimum capital of $7,013 plus commissions. However, instead of buying the stock shares, with the poor man’s covered call strategy, we can simply buy an option contract, which is equivalent to 100 Starbucks shares.
Let’s use the $62.50 strike for our example.
A trading secret that we have been using, is to buy stock options with an expiration date longer than one year also known as LEAPS (Long-Term Equity Anticipation Securities).
Let’s assume we bough the option contract for $13.00.
If we buy the $62.50 strike price for $13.00, we only need to put aside $1,300 instead of $7,013. This would give us the ability to safe $5,713 that we can use in other ways.
The last step is to sell an out of the money call option.
Step #3: Sell Out of the Money Call Option
The last thing to do is to sell an out of the money call option against our in the money call option.
Let’s say we decided to to sell the $75.00 strike for $1.5 which means that we’ll get a premium of $150.
Our total cost for constructing this option spread is $1,300 - $150 = $1,150.
This has reduced our cost further down!
It’s that easy.
Conclusion – Covered Call Option
In summary, the covered call strategy is frequent among long-term traders who wish to amplify their return on shares they own. If you understand what a covered call is and how to properly implement this options trading strategy, you can compound your stock portfolio rapidly.
With a covered call you also get some downside protection. However, the luxury of having this downside protection comes with a cost of capping the upside profit potential on those long shares. Want to learn more? Check out this training on Iron Condor Options Trading.
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