Learn more about what covered calls are, how to use them, the risks, and some variations to mitigate those risks.
(We also published a post on choosing good instruments for trading covered calls. best stocks to write covered calls)
What is Covered Call?
A covered call consists of a purchased stock and the sale of a call option backed by that stock. Let’s illustrate this with an example.
Assume that you purchased 100 shares of Apple (AAPL) stock at $430 per share in April for a total of $43,000. He then sold the May call option on AAPL 450 for $10, or $1,000 total. You would then pay a net amount of $42,000.
So what happens to the AAPL price with different expiry dates? Well, if the AAPL is below $450 at expiration, the call option expires worthless, making $10 more profit per share than doing nothing. will be obtained.
However, if the stock is above $450, the purchaser of the call option will exercise the option and 100 of your shares will be “called away.” For example, let’s say the AAPL rises to $470.
By selling a call option that gives the buyer the right to buy the stock for $450, you are effectively forced to sell the stock for $450 instead of the $470 you can get on the open market.
So, if you hadn’t sold the option, you would have given up the $20 per share you would have earned (ignoring the premium you received initially).
Note that even in this scenario, there is a significant gain. He bought the stock at $430, received a $10 premium from the call option sold, and then sold it at $450. You get a total profit of $30. It’s not as profitable as if you simply bought the stock and sold it for $470 (i.e. $40).
Monthly “income” from qualifying calls
This trade-off of not being able to make a lot of money from receiving a premium even if the stock price is not good is attractive to many investors.
In fact, perhaps the most popular options trade is the sale of call options, where you get a premium for stocks you already own or buy over the long term.
Suppose you own 100 shares of Apple stock and sell a call option at $20 above the current stock price each month.
Unless Apple’s stock price rises by more than $20, they’ll be forced to sell their shares, but they’ll make a sizable profit, so they’ll get a $10 monthly premium.
This may seem like a proposition that the heads win and the tails lose, but it is certainly presented that way in many of the covered call option advisory services out there. In fact, covered calls are usually presented as a low-risk option strategy.
However, as we will see later, this is not entirely true. For any strategy to be successful, there are significant risks that need to be managed.
What’s wrong with a covered call strategy?
So what’s the problem? Are covered calls really low risk? Let’s take a look at the profit and loss chart for this trade.
Can you see the shape? This is exactly the same as the $450 put option sold. And since the profit and loss graph is the same, it will be exactly the same trade.
This is a good example of the “synthetic” option phenomenon. In many cases, a combination of stocks and options can be used to “synthesize” another options position. In this case, selling 100 shares of AAPL stock combined with a $450 call is exactly the same as selling a $450 he AAPL put option.
Now, if I were to ask you if you wanted to sell an uncovered put option, what would you say? Selling uncovered options is inherently risky as it creates unlimited (or nearly so) downside if the trade goes against you.
If you sell a $450 put option that expires in 30-40 days, you will make a profit of about 100 million yen. $30 premium.
However, if the AAPL falls, you could theoretically lose up to $450.
So you think covered calls are still low risk? Did you understand that uncontrolled can actually be very dangerous?
Before we look at how to manage this risk, let’s take a look at: implied volatility. Options trading should not be valued without considering volatility, but in this case volatility is less important than usual.
Investors typically hold sold calls until maturity and either sell next month’s portion as is (if current month’s portion expires) or sell holdings (if significant profit is made). , open a new position (buy stock and sell next month’s options).
However, volatility will affect the amount traded during the month, which will affect the “buyback” price if an investor wants to exit the trade before it expires.
So how do you manage trading risk?
Well, that’s the subject of the next section.
Risk management for covered calls
By now, you’ve learned what Covered Call is, how it can be used, and how it’s uncontrolled and more dangerous than many people think. So let’s take a look at some risk management techniques to complete the covered call considerations.
The main ways in which risk can be managed are:
The first thing you can do is set a stop loss. If the stock price drops by (say) 20%, exit the trade.
This has the advantage of being simple and potentially automated depending on the broker used. It also eliminates 80% of the risks.
However, as with all stop-loss systems, you can lose money unnecessarily. If the stock recovers, you will suffer a 20% loss, but you may not need to. There is nothing more annoying than having a trade canceled just because profits have recovered.
Call-in-the-money sell option
The example above, and the most commonly practiced covered call strategy, is to sell out the money call. In this example, $20 of the money.
Another way is to sell on money call. Suppose you buy an AAPL at $430 and then sell a call option at $410 instead of $450. you will receive approx. $30.
With this strategy, in most cases (i.e. when the AAPL expires above $410), we expect the stock to be terminated with a $20 “loss”. But since you received $30, you have made a much lower risk profit of $10. In fact, the stock would need to fall to $400 to make a loss.
What you’ve given up is the upside of the stock itself. But many investors would be ready to do this to get a 2% monthly profit (in this case).
Suppose you made the money covered call above (i.e. bought a stock and sold a $450 call option) but the stock price fell from $430 to $410.
The $450 call you sold is probably worth very little now (say $2). If you take this opportunity to buy back this option and sell the $430 option (say, $8), you will earn an additional $6 per share for the month.
The danger, of course, is that the AAPL will rebound above $430, forcing us to sell at $430 instead of the potential gain of up to $450.
You can also roll out instead of rolling down. So, in the above example, instead of rolling down from May’s $450 call to May’s $430, he rolls down to June’s $450 call. This allows us to keep the call strike price at $450.
This is my favorite tactic. It is the selection of stocks that pay dividends before the expiration of the option (more precisely, the base date is before the expiration). This will increase your income from trade.
In theory, the dividend should be priced into the call price. That means you receive less call premium, but we’ve found that in many cases this isn’t exactly the case.
Covered Call: Trade Plan
Let’s put together everything we’ve learned so far and come up with a complete strategy for trading covered calls the way epsilon options…
Step 1: Choose a foundation
Pick a “boring” stock that pays a dividend within the next two months. The stock should be above $50 and the historical volatility he should be less than 25%. Must have an annual yield of at least 1.5% (2% is even better)
Stocks of Walmart (WMT), IBM (IBM), Union Pacific (UNP, etc.) are amazing.
Step 2: Buy 100 shares
Buy 100 shares (multiples of 100 for larger budgets) with this underlying stock.
Step 3: Sell In-the-Money Call Option
Sell one call option contract for every 100 shares purchased at the same time.
Here are some points that need attention. The strike price of this call option must be the money’s first strike price and the first expiration after the dividend record date.
Let me explain with an example.
IBM is $187 in October 2013
The next dividend record date is November 10, 2013.
The sold call has two strikes below $187. Since IBM options are denominations of $5 ($180, $185, $190, $195, etc.), the initial strike price (i.e. less than $187) is $185.
The first option expiration date after the dividend is the November 2013 option.
Therefore, you sell the 185 call option on November 13th.
Tip: It’s best to do steps 2 and 3 at the same time. This is called “by-light”. Your broker should be able to help you with this.
make an exit plan
I will remove the position whenever I make a 20% loss
You can always remove the position when you have a profit of 25-30% (there is a little room for adjustment here, you can choose).
The goal is to do a lot of this work over the course of a year and get a few percent profit on each trade.
This should exceed the 20% you get along the way.
Unlike many options trades, most of these trades are expected to be held until expiration when the stock is called (i.e. sold) at the strike price.
(Note: We describe two alternatives to traditional covered calls.
Click here for Synthetic Covered Call >>> Explanation of Synthetic Covered Call Option Strategy
and Covered Call LEAP >>> Covered Call LEAP | Using the Long Date Option in Covered Call Writing )
From the three Covered Call courses, I’ve learned that these courses can generate a small but steady income of 2-3% per month. While this may seem rather small, it is repeatable and most investors hope to accumulate returns of 40% or more annually.
However, this income carries significant risks if not managed. Thankfully, as we’ve seen, there are several methods available to manage that risk.
Call methods covered by the epsilon option make use of these methods (but are not rolled down for the reasons above).
About the Author: Chris Young has a degree in Mathematics and 18 years of experience in finance. Chris is British, but he has worked in the US and most recently in Australia. His interest in options was first sparked by the “Trading Options” section of the Financial Times of London. He was determined to pass this knowledge on to a wider audience and in 2012 founded Epsilon He Option.