Covered Calls

Covered calls are a conservative options strategy that combines a short call option with at least 100 shares of stock. Because the short call comes with an obligation to deliver 100 shares of stock per contract sold, it is only a conservative strategy if I sell it while either holding or purchasing enough stock to satisfy the obligation.

The usual pattern of this trade is that I buy a stock and at some point sell a call above the current price. If the stock remains below the short call on expiration, the option expires worthless and I can then sell another call for the next month. If the stock is at or above the short strike on or near expiration, I may get exercised (called away). This means I must deliver the underlying stock at the agreed strike price. If my short strike is ITM by a penny or more on expiration day, I will get called away - no maybe about it.

There are several disadvantages to this type of trade. The first is that by selling a call, I am putting a limit on the amount of money I can make from a strong bullish move of the stock. The most I can ever make on the trade in this case is the difference between the purchase price of the stock and the strike price of the sold call PLUS the premium received for selling the call.

The other disadvantage is that the stock could suffer a large pullback or bearish turn, which could potentially result in losing the entire cost of the stock. However, since I did receive a premium for selling the covered call, the potential loss would be the cost of the stock minus the premium received.

I'll talk about how to limit the downside risk under trade exits.

Outlook/Analysis

There are typically two ways this strategy is used.

  1. I own a stock that trades options and I want to sell calls to generate premium and reduce my cost basis on the stock
  2. I buy a stock and sell a covered call specifically with the idea of having the stock called away.

I will use covered calls when I am neutral to mildly bullish in the longer term. I don't often adopt strategy #2 unless I find a situation where the premium of the option I may sell is high. This can occur when volatility of the stock or the market in general is higher, which translates to a riskier trade.

My preference is to use strategy #1 (i.e I plan to own a stock for a long period of time). My main objective is to generate additional monthly premium and/or lower my cost basis for the stock.

Think of it this way. If I bought a stock for $22.50 and later sold $25 call, collecting $.50, my cost basis for the stock is now $22 right? Each month I sell a call and it expires, I lower my cost basis by that amount.

Trade Entry


Selecting the right stock

I like to already have a stock in mind that I intend to own for a longer period of time (maybe 6 months to a year or more). This should be a stock that has strong fundamentals or it can be an ETF that represents a sector with a higher potential growth.

I want to reiterate that trading covered calls is a strategy I use primarily when I plan to own the stock for the longer term. Unforeseen factors may cause the stock to not rise in value at the rate I project. I MUST be OK with tying up the capital to own enough stock to sell a covered call.

Covered Calls example trade

As mentioned earlier, since this is a bullish strategy, the stock or ETF I am selecting should be one I'm bullish on... preferably as indicated by an established trend (higher high & higher low).

If I'm looking for a good covered call play (strategy #2), I will actually search for stocks having options with a higher implied volatility. Most brokers have research tools for that kind of search. I'll then view the chart of the stock to make sure it has a neutral to bullish bias to it.

Timing the entry

There are two parts to trading covered calls. One is the purchase of the stock and the other is the sale of the call. I do the entry differently depending on which strategy I'm using.

If I own the stock or am planning to own the stock (strategy #1), I prefer to time the entry on a bounce off support but at a point where the stock is more oversold. I will then wait for the stock to make a move, allowing it to move into a more overbought area before selling the call. I do this because I want to increase my chances of not having the call exercised on me. By waiting until the stock is somewhat overbought, the chances increase that there will be a pullback.

When I don't already own the stock (strategy #2) and I'm intending to buy the stock and sell the call all at once, I prefer to wait until the stock is in an overbought stage. This can be indicated by using an oscillating technical indicator such as the stochastic indicator or an RSI indicator.

Selecting the right options

The choice of option to sell is based on several factors. My objective is to receive as much premium as possible. If I bought the stock for the longer term, my goal is also to not have the stock taken away. Here is the approach I take for each strategy.

  1. I look to sell a call above an established resistance point. I am trying to maximize my premium but I also want a lower risk of being exercised. Usually, this will be one or two strikes away from the current price.
  2. I will look to sell the next strike out of the money. I'm looking to maximize my profit by being called out. If I'm more bullish, I'll definitely look at one strike out of the money. If I'm less bullish, I'll look at the at-the-money (ATM) strike.
The tricky part with this strategy is understanding the impact of either being called away or not being called away. With strategy #2, the ideal goal is to be called away.

Continue to page 2



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