3 Step Covered Call Strategy – Stealing the Premium

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Learning how to trade a covered call is one of the best ways you can earn consistent income in the stock market.

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, how selling covered calls work, and how they can generate income streams.

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Covered calls are 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. Click To Tweet 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.

Covered Call Strategy

One options contract consists 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.

Covered Call Option

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:

  • The stock price stays under $50.
  • The 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 in the 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 month 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 a 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 bought the stock for $45 and we generated a $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 options traders with less money. This strategy is a good one and traders refer to it as the poor man’s covered call.

What Is A Covered Call

In the options 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 mean 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.

See below:

Step #1: Choose a Low Volatile Stock for your covered call

Let’s take as an example, Starbucks a low-beta stock.

Remember we want a stock with low volatility.

Low-Beta Stock

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% then 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 (Poor Man’s Covered Call)

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.

Buy In The Money Call Option

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.

This is the Smart Man Covered call Not the Poor Man Covered Call.

Some people call it a poor man’s covered call but I say it is smart, because you can earn a great deal more without a lot more risk.

Example if I want to buy 100 shares of a stock for $100 that will give me the earning power of roughly $118 per week which would be about a 1% ROI per week, compounded is  over 100% return!

Now if you do a so called poor mans covered call the deep in the money call would would only cost you $2,800 instead of $10,000.

What that means is that you can earn potential 4% a week which compounded would be about 143% return on investment.  Of course using the options version increases risk because of increased volatility with options but with practice and training you can do it well.

The last step is to sell an out of the money call option.

See below:

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.

Sell Out The Money Call Option

Our total cost for constructing this option spread is $1,300 – $150 = $1,150.

This has reduced our costs down further!

It’s that easy.

Frequently asked questions: Covered Calls

How to Make 20,000 a month selling covered calls?

To make $20,000 a month selling covered calls, own a of at least $400,000 choose stocks with high implied volatility, and consistently sell out-of-the-money call options with short expiration dates.   If you make $4,700 a week that is roughly 20k per month.

What are the Risks of a Covered Call Strategy?

The biggest risk is loss of potential gains. That means that if your stock goes up fast you will have to sell that stock for the price of your option and you will miss out on some potential returns however you will still be making money just not as much. In addition if the market drops you will be holding a stock that is losing value but the earnings from selling the premiums will be helpful.

Should I sell Weekly or Monthly Covered Calls?

It depends on your goals it takes less time if you only trade once per month. However if you want to make weekly revenue you need to sell weekly, you will make more money in the long term because you will get 52 chances to trade verses only 12.

How to eliminate risk using covered calls?

The best way to eliminate risk is to use high quality stocks that you have a great confidence in, always do research on the stock and keep track of performance. However even if the stock is going down you can still earn weekly cashflow from it which is a great bonus.

How to avoid getting your stock called away?

The best way to avoid getting your stock called away is to do a strike price that is farther out of the money. Also if you choose to roll your stock you can avoid it from getting called away. Of course if it gets called away you can always buy it back or sell puts to try to get it back at a better price.

Can I lose money trading covered calls?

Yes, you can lose money trading covered calls in several ways:

Opportunity cost: If the stock’s price rises significantly above the strike price, you miss out on potential gains, as you’re obligated to sell the stock at the strike price.

Stock price decline: If the stock price falls below your purchase price, the premium received from selling the call may not be enough to offset the loss in the underlying stock.

Assignment risk: If the option is exercised, you must sell the stock, potentially incurring tax liabilities or disrupting long-term investment strategies.

Limited protection: While the call premium provides some downside protection, it may not fully cover the decline in the stock price.

Benefits and Risks of the Covered Call Strategy

The Covered Call Strategy is one of my favorites but everything has advantages and disadvantages so here is a complete list of them here.

The Pros

  1. Generates income: Selling covered calls can generate income in the form of premiums received from selling the call options.
  2. Lowers cost basis: If the stock price does not reach the strike price, the premium received can lower the cost basis of the stock.
  3. Limits potential losses: The premium received from selling the call option can help offset any losses from a decline in the stock price.
  4. Provides some downside protection: Selling covered calls can provide some protection against a declining stock price.
  5. Can be used to exit a position: Selling covered calls can be used to sell a position that you may have wanted to exit.
  6. Can be used to manage risk: Selling covered calls can be used to manage risk in a portfolio by generating income and limiting potential losses.
  7. Can be combined with other strategies: Selling covered calls can be combined with other strategies, such as buying protective puts, to further manage risk.
  8. Flexibility in choosing strike prices and expiration dates: Selling covered calls provides flexibility in choosing strike prices and expiration dates to suit individual investment goals and risk tolerance.
  9. Increases return on investment: Selling covered calls can increase the return on investment of a stock position.
  10. Requires lower capital investment: Selling covered calls requires a lower capital investment than outright buying shares of the underlying stock.

The Cons

  1. Potential loss of potential gains: When you sell a covered call, you limit your potential gains in the stock if it increases in value beyond the strike price of the call option.
  2. Limited protection from market downturns: Although selling covered calls can provide some downside protection, it does not eliminate the risk of losses.
  3. Risk of stock assignment: When you sell a covered call, you are obligated to sell your shares at the strike price if the buyer exercises the option.
  4. Opportunity cost: Selling covered calls requires you to tie up capital in the underlying stock, which may limit your ability to pursue other investment opportunities.
  5. Taxes and fees: Selling covered calls increase taxes on the premiums received, and commissions and fees go up as well.
  6. Market risk: Selling covered calls exposes you to market risk, including fluctuations in the stock price and general market conditions.
  7. Time decay risk: As the expiration date approaches, the time value of the option decreases, which can reduce the premium received from selling the call option.
  8. Counterparty risk: Selling covered calls involves counterparty risk, which is the risk that the buyer of the call option may default on their obligation to purchase the underlying shares.
  9. Complexity: Selling covered calls can be a complex strategy, and it is important to have a solid understanding of options trading before engaging in the strategy.
  10. Margin requirements: If you sell covered calls in a margin account, you may be subject to margin requirements and additional risk.

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.

Thank you for reading!

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Covered Call Strategy Pdf

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15 Price Action Patterns Insiders are Using If a hedge fund managers were using 15 specific price action patterns would you want to know?

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  1. StockTrader.com provides weekly stock market recaps, 100s of educational articles, and a Trade Journal tool. Our mission is to empower the independent investor.
    website: stocktrader.com/blog

  2. In your diagonal spread example, it seems like it might be a good idea to buy the in-the-money call with long duration and then sell shorter duration out-of-the-money calls so that you can sell multiple times. But calls with more time left also cost a lot more. So optimizing which expiration date calls to use is not an easy task. Is there a good rule of thumb to get you close to the optimum? Or is there a straight forward way to calculate it?
    For example:
    Buy a call that expires 4 months from now. Then sell 1 month covered calls once a month and collect 4 small premiums or sell one 4 month call. Or maybe split the difference and sell 2 month calls twice.

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