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# Covered Calls - Page 2

There are tools available to help with the analysis. One nice tool (the covered calls calculator) can be found on the OIC (Options Industry Council) website. Here is an example of using the tool with the numbers I discussed above (buying a stock at \$22.50 and selling the \$25 call).

I only entered in a couple of parameters. I selected \$22.50 for the purchase price of the stock, I chose the May expiration and selected the \$25 call for which I received \$1.75. I didn't bother capturing information about dividends and commissions. If you want a more exact estimate, these can be entered as well.

Additionally, some information is then calculated for me. The cost of the stock (100 shares) is based on my \$22.50 purchase price. However, I also sold the \$25 call for \$1.75 making my net cost of the trade \$2075.

As is shown here, there are two potential outcomes. If the stock is above \$25 on or near expiration, I will be called away and I'll make \$425 or 20.5% return on my investment of \$2075. If the stock is unchanged (or at least remains below \$25 by expiration), I'll make \$175 or 8.4%.

#### Analyzing risk/reward

Understanding the risk and reward is a little more complicated with covered calls. To understand better, let's consider four scenarios.
1. The stock climbs to \$25.01 on expiration
2. The stock climbs to \$50 before expiration
3. The stock remains unchanged at \$22.50 at expiration
4. The stock falls to \$15 sometime before expiration
In the first case, we realize the maximum reward. I purchased the stock for \$22.50 and was forced to sell the stock to someone else for \$25 for a \$2.50 profit. But... I also collected \$1.75 premium for selling the call. So, my total profit in the trade is \$25 - \$22.50 + 1.75 = \$4.25. For 100 shares, that's \$425, which is what we saw in the covered call calculator above.

In the second case, the outcome is the same as in the first case. I still make \$425. However, I wanted to point this scenario out because that was one of the risks of covered calls. I may miss out on a large move of the stock.

In the third case, the stock remains unchanged. I am not called away AND I get to keep the \$1.75 I got for selling the \$25 call. According to the covered call calculator, I make an 8% return if this happens. To further complicate this scenario, consider two variations. What if the stock goes all the way to \$24.95 by expiration? In that case, I keep the \$1.75 AND I get to sell another call... preferably at a higher strike. This is the ideal outcome for my #1 strategy for trading covered calls.

The other variation involves the stock falling say to \$20. The analysis chart above suggests that I'll lose money if this happens. But do I? What is my cost basis at this point in the trade? I paid \$22.50 for the stock but I sold a call for \$1.75. That leaves my cost basis in the trade \$20.75. What if I could sell the \$22.50 call for the next month and take in \$1.50? My cost basis in the stock is now \$19.25. Now, if the stock moves up above \$22.50 by the next expiration, I make \$3.25 on \$19.25 investment, which is a 16% return on the trade.

The fourth scenario is probably the worst possible outcome of this trade. If left alone and the stock falls to \$15 or worse by expiration, I will lose money. I will lose exactly my cost basis, which is \$20.75 - \$15 or \$5.75 x 100 = \$575. Whether or not I can tolerate this loss depends a lot on how large my position is relative to my portfolio. What can I risk in this trade? If I use my \$1000 per trade loss limit, then I can only trade 100 shares. If I fudge a little bit and allow a \$1150 loss, I can trade 200 shares.

What if we created a variation to this last scenario? If I entered this trade based on an bullish trend, then there should be some support below the current price but above \$15 that I might use as an exit point if broken. In the above stock chart, we can see an established support level around \$19.25. One way I could protect myself from a larger loss is to create a closing trade based on a break of the \$19.25 level. In that case, I could sell the stock and buy back the covered call. With a drop in price, the call would be cheaper than I originally sold it for, which will help offset some of the loss of the stock price.

If the fall of 2008 has taught us anything it is that it is good to have a worst case plan in place and act on it.

#### Placing the order

Once again, how this order is placed will depend on the strategy used. When I use covered calls strategy #1, I will buy the stock at some point and I will set the number of shares purchased based on my planned exit independent of the call I'm selling. I may choose to use the above exit strategy of closing the trade when the stock breaks through the \$19.25 support level. If I entered at \$22.50, then my loss would be \$3.25. With a tolerable loss on this trade of \$1000, I would only buy 200 shares of the stock (1000/ (3.25x200) ).

Later, when the opportunity arises, I can then sell 2 contracts of the \$25 call using an order like 'sell to open 2 contracts with a limit price of \$1.75'.

With covered calls strategy #2, I can actually create the order simultaneously. Usually when I do this, the order price will be the combined net price of the stock minus the credit for the call sold. On some platforms, the quantity of stock can be entered separately from the quantity of calls sold. It is important to make sure that the two stay synchronized at 1 contract for every 100 shares.

One final point to keep in mind is the overall cost of the trade. We've established that the net cost of the trade will be \$20.75. That's \$2075 for every 100 shares. If I buy 200 shares and sell 2 contracts of the \$25 call, it will cost me \$4150. I need to be comfortable with tying up that much capital for a longer period of time.

In the risk/reward section I outlined some of the possible outcomes for the covered call trade we have been looking at. In reality, I tend to use a few different rules. These are based on which strategy I'm using.

#### Strategy #1 - covered calls on stocks I want to own

Remembering that my goal is to keep the stock for the long term, I'll exit under the following conditions.

• Stock price at or above the strike price of the call I've sold. I'll typically roll the call out to the next month and I may also roll up to the next strike if I can do it for some additional premium. My #1 goal is to capitalize on the long term growth of the stock so taking in a lot of premium is less important to me.
• Stock price is below my exit point I established as a support level (i.e \$19.25). In this case, I'll sell my stock and buy back the call to close out the entire trade
• The stock is near an overbought area but below my short call. I may look for an opportunity to roll to the next month... again possibly moving up another strike. I'll do that by buying to close my short call and selling to open a call in the next month and potentially a different strike price.

#### Strategy #2 - covered calls for fun and profit

Knowing that my goal is ultimately to be called away on the trade, my exit rules are slightly different. I'll exit under the following conditions.

• Stock price is below my exit point I established as the support level. This represents my intended maximum loss so I need to be prepared to exit when this occurs.
• 4-7 days before expiration and the stock is below the strike price of the call I sold. At this point, there may not be much value in this call and I will look at an opportunity to roll that call to the next month for additional premium. I'll do that by buying to close my current short call and selling to open a new call position in the next month, usually at the same strike price.

## Summary

Covered calls are a nice conservative strategy for generating income while taking advantage of a steady increase in the underlying stock price. As I mentioned, I prefer this strategy when my ultimate goal is to buy and hold a stock for a longer period of time. In that case, my objective is to simply generate income and reduce my cost basis on the stock.

As I've discussed the various steps to trading the covered calls, I've followed a fairly structured approach (selecting the right stock, timing the entry, selecting the right options, entry, exit, etc). These are based on a set of trading rules I follow, which are part of an overall option trading system. This is a critical aspect of successful options trading. I've found I can't be successful trading any strategy just by knowing the mechanics. Having a system that defines what I do every time I trade is what helps me be consistent in my profits.

 Outlook: Neutral to slightly bullish longer term Max profit: Limited to the credit received for the short call sold plus the difference between the purchase price of the stock and the strike price sold. Max Loss: Theoretically, the cost of the stock, although this can (and should) be limited with a stop loss. Net Position: Net long Time decay effect: Benefits from the passage of time

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