Covered Call
This page is in both “Educational” and “Philosophy, Strategy and Risk” sections of Main Street beats Wall Street. Covered Calls are in the first chapter of every book on Options as an important tool in trading and it’s known as the strategy with the lowest risk. Every options trader, from beginners to professionals, must know and understand what a Covered call is and will use it as a strategy many times in their trading career. In fact, a new trader will be limited to Covered call trading by their broker until they get more experience. Widely viewed as a conservative strategy, professional investors often write Covered calls to increase their investment income. Beginners and individual investors/traders must take the time to learn and benefit from this simple, effective option strategy. By doing so, investors will add to their investment arsenal and give themselves more investment opportunities. Let’s take a look at the Covered call, define it, and examine ways you can use it in your portfolio.
Definition: A Covered call is an option strategy where the owner of a stock, writes (sells) an option against that stock in an attempt to generate extra income from that stock. The money received is called the Premium.
Example: I own 100 shares of XYZ corp and I sell someone the option to buy my 100 shares of XYZ corp at a specific price by a specific date and in return the buyer of the option pays me a premium. A Covered Call means I own the stock I am selling an option against. If I sell an option on a stock I do not own, this is called an Uncovered Call or Naked Call. The key to selling Covered Calls is that the seller of the option owns the underlying stock before he sells the option, or buys the stock and sells the option at the same time. If I buy the stock and sell the Call on the same transaction, this is called a “Buy-Write.” The one transaction consists of buying the stock and selling the Call Option. This is a Covered call, but when I buy the stock and sell the call on the same transaction I pay only one commission fee. If I sell an option on a stock I do not own, I sell an Uncovered Call. If I decide to buy that stock at a later date, the Uncovered Call becomes a Covered call. Read as much as possible on this subject. Covered calls are a basic fundamental of option trading.
Now that we understand what a Covered Call is, let’s look at a few scenarios of what can happen once you write (sell) a Covered Call. I bought 500 shares of XYZ Corp at $9 per share. After owning XYZ Corp for a while it is now selling for $10 per share. I want to sell an option for someone to buy my 500 shares of XYZ Corp for $11. I want to sell my Call Option with the Expiration Date 30 days out. So, if today is January 1st, I want to sell the January 30 Call. I look on the Option Chain and see the Call Options are selling for 60¢. I like the Premium of 60¢ so I put the order in to sell 5 contracts (500 shares) of the Jan 30 XYZ Corp $11 Call Options at 60¢. The total Premium is $300 (60¢ X 500 shares). This is a Covered Call. Let’s take a look at how this might play out.
- Scenario #1: On January 30th XYZ Corp is selling for $12 per share. The Option is In-the-Money. Since I have a contract to sell my stock for $11, I will get “called out” (assignment). This means the buyer of my Call Option will take my stock by buying it for the $11, the Strike Price of our deal. I bought my stock at $9 and I sold for $11. This gives me a $2 profit on the stock, which is $1000 on the 500 shares. Plus I keep the $300 Premium I received for selling the Option. The profit made is the $1000 + $300 for a total of $1300. Since I had a Strike Price of $11 and the stock went to $12, I had a $1 per share “Opportunity Lost.” Please read the page on Opportunity Lost. If I never sold the Call Option for the $300 Premium, I could have made one more dollar on the sale of the stock. I would have made $3 on the stock for a total of $1500 profit. But since I received the $300 Premium, my profit was $1300 and my Opportunity Lost was only $200.
- Scenario #2: On January 30th XYZ Corp is selling for $10 per share. The Option is Out-of-the-Money. My Strike Price is $11 so the Option will expire. The buyer of my Option will not buy my stock because the stock is selling for $10 per share and the Strike Price is $11. Why would he pay me $11 when he can get it on the open market for $10? The Option expires, I keep the $300 Premium and I keep my stock. If I want I can sell another Call Option on my shares that are no longer under contract.
- Scenario #3: On January 30th XYZ Corp is selling for $11 per share. The Option is At-the-Money. When it comes to me losing my stock, this is a toss-up! The buyer of the Option might buy my stock or he might not. Either way I keep the $300 Premium. If he buys the stock I make $2 on the stock, plus keep the $300. If he doesn’t buy my stock, I keep the stock and the $300 Premium.
- Scenario #4: 5 days later on January 5th XYZ Corp is selling for $7 per share. This is the big risk with Covered calls. In 5 days XYZ Corp takes a big drop to $7. I look at the Premium and it is now at 8¢. Since I sold a “Short Call” for 60¢ I can now buy the Call back for the 8¢ it is now going for. I would get completely out of the deal for $40 (8¢ X 500 shares). Now I own the stock with no Option sold against it. On January 15th XYZ Corp was selling for $10.50 per share. The stock had a big bounce back. I look at the “Option Chain” and the $11 Call is now selling for 45¢. I can now sell another Call on my stock if I want and I get another Premium of $225 (45¢ X 500 shares). I’m back in the game and the result will be scenario 1, 2 or 3.
Scenario #4 is the one I fear the most. I do not like owning stock and being locked into a position where I can’t sell the stock because I have a contract to deliver my stock at the Strike Price, and the stock takes a big drop. This is covered in “My Philosophies & Strategies” and in some of the strategies listed below.
Pages you must read to completely understand all the scenarios are: “In, At & Out-of-the-Money”, “Opportunity Lost”, “Long & Short Positions”, “Option Chain” and the “Buy-Write” section below. Also go to the Glossary and lookup: Contract, Strike Price, Premium, Expiration Date, Assignment.
When a trader decides to use the Covered Call strategy, he will have an idea on what he wants to happen and what can possibly happen at the conclusion of the trade. Below are some possible ideas and strategies going through a trader’s mind when using Covered calls. Picking a certain strategy may help determine which stock a trader will use while selling Covered calls to achieve his goal and satisfy his motivation. Analyzing any investment requires answering the following question: Is the potential profit worth the potential risk? Covered Calls are a common strategy because of the low risk factor. When choosing a Covered Write, stock selection is the most important element. While not many stocks fall to the point of being worthless, some stocks do suffer substantial price declines. Because of this risk, an investor must be confident of the stock investment itself before using the Covered Call strategy or determining their motivation. Below I’ll go over some possible motivations an investor might have when selling Covered calls.
Covered Calls as Insurance
I personally use Covered calls as insurance quite often. When I use the word insurance, I’m talking about hedging. As a hedging mechanism, Covered Calls are a prudent play. As you read this blog, you will read many times, I’m not a big fan of owning stock. I make my money selling options but while trading options, even I get caught owning stock. and when I do, I sell Covered calls to bring in premiums to hedge against the stock taking a dip. If the stock takes a dip I have the premium money to help soften the blow of the stock going down. In the situation of owning stock, my strategy is selling Covered Calls for the premium as insurance, and my motivation is to get assigned. Over the years I’ve seen many, many stocks go up & down, up & down, and if you diversify as the professionals say you should, some stocks go up and some go down and you end up even or down a little. Why do you think the pro’s who are controlling the mutual funds are doing 5% – 15% annually? If you’re lucky! I know option traders who laugh at returns like that. We all are going to go through the ups and downs while owning stock. That’s inevitable. You might as well have an outlet to bring you some extra cash every week or month, to buffer a potential fall and to pad your bank account along the way.
Selling Covered Calls – Wanting to be Assigned
As you just read in my section about selling Covered calls as insurance, I do not like investing in stock. I trade options! Millions of investors invest in stock with the buy and hold theory. It’s just not for me. When I do buy a stock, it’s normally for the strategy of writing Covered Calls, and my motivation is normally to get assigned. Most times I’ll do this with a Buy-Write. I’ll pick a stock, Strike Price and Expiration date to insure assignment. Most of the time I’m not in this game for a big stock gain, but for the premium. If a stock is at $20 per share, I might sell the 20, 21 or $22 Call. I’ll pick an Expiration date of 1 or 2 weeks out. I’ll pick a stock that is on the move. If great news came out on the stock, I might pick a Strike Price a little higher to get assigned with a larger capital gain. It’s not that I don’t want to make a profit on the stock while selling Calls, I want to get into a position and get completely out in a short period of time. Sometimes, in hindsight I could have made more money but no one knows where a stock is going with 100% certainty. Since no one can predict with 100% certainty, I’m happy with my slow and steady, steady and slow method of trading. If we could predict with 100% certainty, we would never sell Calls, we would just pick stocks we know are going up, with 100% certainty. Now that we established there are no stock market crystal balls, I feel, if I get out making money, I’m a winner! If I made money, I did not lose money; I move on. Selling Short Calls, for many, might not be a popular strategy for stocks on the move, but it is for me. Many times I’ve sold Covered calls (Short Calls), didn’t get assigned and ended up holding a stock for many months that turned downward. I don’t want to hold the moving stock long enough to where it hits resistance, starts going down, and I get caught holding it for a long time until it recovers. I want in and out, and on to the next deal. No one ever went broke taking a profit. Keep the money rolling in, not holding stock waiting for it to recover.
Now that you are starting to see my philosophy and a strategy. Many times to insure assignment I’ll sell In-the-Money Covered Calls. Let’s say I’m looking at XYZ Corp which is selling for $20 per share and I buy 1000 shares. I’m interested in a 1 or 2 week Expiration Date. I might sell the $21 Out-of-the-Money Covered Calls for a premium of $.50. On 1000 shares this premium would bring me a total premium of $500. My biggest worry in this deal is that the stock takes a dip and at Expiration I do not get assigned. Meaning, if on expiration the stock is selling for $$19.75 I will not get assigned and I own XYZ Corp at a lower price than where I bought. Now it might continue down and I’m stuck in the stock for a while.
Instead of the Out-of-the-Money Call, If I decided to sell an In-the-Money Covered Call, I might go with the Strike Price of $19. If the $21 Call was selling for $.50, the $19 Call will be in the area of $1.45. This In-the-Money Call premium will bring me in $1450 on the 1000 shares. In this case, If I get assigned, I will lose $1000 on the stock because I bought at $20 but I brought in a premium of $1450 for a profit of $450. Granted, the $21 Call brought me in $500 but the $19 Call gives me a little more insurance to get assigned and the trade-off is only $.05 ($50). The In-the-Money Call brings in more premium because it has Intrinsic Value. The stock was at $20 and I sold the $19 Call for $1 in Intrinsic Value. If the stock dropped below the $19, you keep the stock but you also keep the entire larger premium of $1450. This is a very real situation. In fact, for this example I used the stock price and premium numbers from the stock GoPro. This would have been an 8 day deal for a profit of $450 on a $20,000 investment to buy the stock (1000 shares at $20 per share). This is a 2.25% return in 8 days. That would be over 100% annualized. With In-the-Money Covered Calls you are in for the premium only. You will not make money on the stock. This is one of my favorite Covered Call strategies.
Here is a list of big name stocks that are at the same price, down or down big, from 2 years ago to date. Granted, there are plenty of stocks that are up or up big from 2 years ago, but can you pick them with some level of certainty and consistently? These are huge names that are in millions of portfolios and mutual funds, and there are many more! My point is, if you were going to have a diversified portfolio of stock with a buy and hold strategy, the odds are you would have one of these names or other big names where the stock price today is the same, down or down big from 2 years ago. Follow “Main Street beats Wall Street” and you will see what my account will do in the next 2 years.
Caterpillar Whole Foods Halliburton
U S Steel Avon JCPenny
John Deere Angie’s List Harley Davidson
IBM Wal-Mart Twitter
Coca Cola Barnes & Noble Alcoa
Selling Covered Calls – Wanting to Keep Your Stock
Not too often do I want to keep my stock when selling Covered Calls. But there are times when I sell Calls and do NOT want to lose my stock. Having said that, I will say with confidence that most Covered call writers do not want to get assigned. Many Covered Calls are done by investors that previously own the underlying stock. The stock is taking a break or has hit resistance and the investor feels it will trade sideways for a while. The investor will take advantage and grab some premium money while the stock is not moving up. This is also insurance income for when the stock takes a little dip, also called hedging. This investor wants to keep the stock; once the stock starts moving the investor will not sell Covered Calls for the premium, they will thrive in the stock gain. The Strike Price will be set strategically to try to prevent assignment.
Getting Paid to Sell Your Stock
I do not do this strategy but there are plenty of investors who do. “Getting paid to sell your stock” means, selling a Covered Call on stock you own to grab premium money before you dump the stock.
Example: You bought 500 shares of XYZ Corp 1 year ago for $20 per share. Today XYZ Corp is selling for $27 per share. You feel the stock is peaking so you decide to sell the stock at $27. You can just sell the stock when you feel the stock peaked or you can sell a Covered Call with the Strike Price of $27. You look at the Option chain and see the 30 day $27 Call is going for $1.50. If you sell that Call, you agree to sell your stock for $27 per share, any time for the next 30 days and you would receive a premium of $750 ($1.50 X 500 shares). You will get paid $750 to sell your stock for $27 per share. If in 30 days the stock continued up and went to $29, you would have an “Opportunity Lost” situation because as a result of selling the Call you did not get the extra $2 in capital gains. BUT, you would not have owned the stock because you wanted to sell for the $27 per share 30 days ago. So, this worked out great because you still sold the stock for $27 and you made another $750 in premium. The reason I don’t do this strategy is, if after 30 days the stock went to $14 per share, you never got to sell your stock that you didn’t want 30 days before.
Buy-Write
A Buy-Write is a trading strategy that consists of buying a stock and writing (selling) a Call Option at the same time, technically, on the same order. The result is a Covered Call while paying only one commission. There really is no difference between a Covered Call that is opened on a previously owned stock and a Covered Call opened as a Buy-Write, however, there can be a huge difference for the motivation for opening the position. Some of the motivations are mentioned on this page. Many traders have many different philosophies, strategies and motivations when it comes to the approach they take toward investing. When it comes to Buy-Writes most traders will have the same reason for doing them. They look for an up trending stock and write short contracts. You will make less money but you will be in and out much quicker with less risk. Most do Buy-Writes for the premium not to hold stock long term. Like I said, quick profit and move on. No one ever went broke taking profit. Let’s examine some reasons for Covered Calls on previously owned stock and a Buy-Write.
- Covered Calls on previously owned stock: The most common reason for selling Call on a Stock previously owned is because the stock owned has hit resistance and it looks like it might trade sideways for a while. This gives the seller a chance to bring in extra money while the stock is not going higher. With this motive, most investors will not want to lose their stock. Some will sell Calls because they are ready to sell the stock. If the investor believes the stock has peaked and wants to sell, he can sell a Call with a Strike Price he feels will get assigned and collect a premium while doing so. This is sometimes called “getting paid to sell stock.” It is never smart to sell a Covered Call on a stock in a big uptrend. Why take a chance on being assigned with a stock moving up? You will always make more money on a stock gain of a moving stock than a premium collected.
- As a Buy-Write: While selling Calls on stock previously owned and selling Calls as a Buy-Write are both Covered Calls, the motive for doing each are different. The previously owned stockholder is trying to bring in some premiums while the stock is on a temporary break and moving sideways or down a little. I am more of a Buy-Write trader. We look to get in and out of the position quickly while not holding stock for any period of time. The best time to do this is when the stock is in an uptrend. The stock moving up will give a better chance to get assigned to end the deal.
Converting an Uncovered Call to a Covered call
There is another way to have a Covered Call on a stock without selling a Buy-Write or owning a stock and selling a Call. I call it “Converting an Uncovered Call to a Covered Call.” This I do very frequently; quite often a few times a month. I do this often because my favorite strategy is selling Naked Calls, also called Uncovered Calls. If I sell a Naked Call and the stock approaches my Strike Price, I will cover my Call. If you don’t cover the Call and the stock continues to rise, you will get into a situation where you have to buy the stock at a higher price and deliver it at a lower price, the Strike Price. You will lose the difference between the Strike Price and the price of the stock.
Example: XYZ Corp is selling for $20 per share. I sell 10 contracts of the 1 week $22 Naked Call and receive a $.25 premium for a total of $250. Half way through the week XYZ Corp starts to go up faster than I anticipated and hit $21.75. I get a little worried because I still have 2 days until expiration and I have to deliver the stock at $22. I decided to “Cover my Call” with the purchase of 1000 shares of XYZ Corp. On Friday (Expiration Day) XYZ Corp closes at $22.50. This turned out to be a great deal; in my book! I sold the Call, received a $250 premium, delivered the stock making an additional $250 on the stock sale, deal over. This is what I look for with my strategy “1 week/1%.” The only thing that would make this better is not having to cover the Call and the option expired. It would be taking in $250 with no investment. But the way it went, I brought in the $250 with no investment, then I invested $21,750 buying the stock and brought in the additional $250 on the stock sale. This is better than 2.2% return for a 1 week deal. If you annualize this return it would be 110%. There is no reason why I can’t do this every week for the year. This is the type of return I live for while selling options. If I did not cover my Call, I would have had to buy the stock at the price on Expiration Day, $22.50 and deliver it at the Strike Price, $22. I would lose $.50. On 1000 shares that’s $500. It’s very important not to get into this situation. Not planning on buying the underlying stock (if needed) when selling Naked Options is what makes this strategy extremely risky.