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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
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%.
Understanding the risk and reward is a little more complicated with
covered calls. To understand better, let's consider four
- The stock climbs to $25.01 on expiration
- The stock climbs to $50 before expiration
- The stock remains unchanged at $22.50 at expiration
- 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
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
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
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
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
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
exit rules are slightly different. I'll exit under the
- 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.
Covered calls are a nice conservative strategy for generating
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.
to Covered Calls - Page 1
||Neutral to slightly bullish longer term
||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.
||Theoretically, the cost of the stock, although this can
(and should) be limited with a stop loss.
||Benefits from the passage of time