Options Trading Strategies : The Covered Call

Covered Calls Are A Popular And Profitable Trading Strategy

Covered calls are a popular and profitable trading strategy.
Covered calls are a popular and profitable trading strategy. | Source

What Is A Covered Call

Covered calls are one of the simplest and most effective options strategies in use today. The technique is used by traders of all varieties as a way to capitalize on time decay, profit from options writing and reduce the risk of trading long options. To successfully employ this strategy you must understand the risks and rewards of the trade as well as any possible scenarios you may encounter. Below you will find an in-depth look at what a covered call is, why you want to trade them, how to trade them and the possible outcome of your trade.

What is a covered call

Covered calls are an unlimited risk/limited reward trading vehicle. It is a combination position that allows traders to earn income from stock they own, limit their risk in new trades or profit from time decay and changes in volatility. Traders use cover calls when they are seeking to lower risk and enhance gains in a neutral to bullish investing environment. Covered calls are also known as buy-writes and are a type of combination position. It is called a combination position because it combines a stock and option position into one net trade. It is a simple form of combination investment and a good way to gain experience with options writing.

What Does Covered Call Mean

The term covered-call means that the calls you sell are covered by stock that you own. Since option contracts represent 100 shares of stock you may sell one contract for every 100 shares that you own. If you own 1100 shares of Ford you may sell 11 options contracts against that stock position.

Why You Want To Trade Covered Calls

In every options trade there is a buyer and a seller. As a buyer of options you are granted the right to buy stock at a set price for a set amount of time. In return for this right the option buyer pays a fee, or premium, for the option. This is the price you pay to buy a call. Anyone who has ever traded options should be familiar with this.

It is well known in the option trading community that options are more likely to expire worthless then to expire with gains.It is also well know that it is more profitable to be on the sell side than the buy side. Covered calls are a way for traders who would not otherwise be allowed to sell options to enter the market and earn income from option premiums.

Covered call trading is often compared to lease-options in the real estate market. With a lease option an individual can rent a property for a set time with an “option” to buy the property at a predetermined price. The landlord (options seller) earns income from the lease (options premium) and will potentially sell the property (stock) at a predetermined price (option strike).

Trading covered calls is essentially the same thing. You are renting out your stock and earning income in the form of option premiums. The renter, or call buyer, has the option to buy your stocks at a set price.

To build a covered call position you buy one long stock position and then sell one off-setting short option position.

Covered Call Risk Reward Analysis

Covered calls return the max gain when stock price moves above the strike price of the call option.
Covered calls return the max gain when stock price moves above the strike price of the call option. | Source

The Risks And Rewards Of Covered Call Writing

Covered calls are an attractive investment for a number of reasons. For one, the combination of long stock and short option provides a net position with a lower risk profile. For another, the option premiums also generate cash flow and enhance gains in sluggish markets. The basics of the trade are simple and risk is reduced but there are still risks involved. You should fully understand the risks of trading before you begin this or any other trading strategy.

The Risks Of Covered Calls

  • Limited Gains- In return for lowering your risk covered calls also limit your gains. Once the stock goes above the strike price of the option you earn the maximum profit and any further gains belong to the owner of the call. The maximum return on a covered call trade can be represented by this equation: Maximum return = Strike price – Break Even.

  • Exercise/Expiration- As the seller of options you may be required to deliver shares of stock on expiration day. This obligation is covered by the shares of stock you already own and used to write the calls. What this means is that if the stock moves over the strike price you will have to sell your stock to the holder of the call you sold. It is important to understand this and not use the covered call strategy with any stock you do not want to sell.

The Rewards Of Covered Calls

  • Lower Risk Profiles – In an open stock trade your risk and reward are both unlimited. The price of the stock could go up indefinitely or it could go down to zero and you lose everything. Covered calls are often referred to as limited-risk investments. You can lower your risk in a trade by using the covered call strategy but your risk exposure is still 100% because the underlying stock could go all the way down to zero. Your risk is limited because of the premium you earn by selling a call. Your risk in the trade can be represented by this equation: Break Even = Cost basis – option premium.

  • Generate Cash Flow – You can generate cash flow with stocks you already own by selling options and earning option premium payments. Stocks you own that are trending sideways or trapped in a trading range are especially good candidates for creating cash flow this way.

  • Enhance Gains – Traders are always looking for profits. In neutral environments directional trades are not as effective, cash flow can be limited and profits are harder to come by. Covered calls are a good way to enhance gains and lock in profits through neutral markets, dips and corrections.

Covered Calls And Time Decay

Time decay is another important factor when considering which options to sell. Time decay is the amount of value an option loses over time.Each day, the amount of value an option loses is displayed as its theta. As the option gets closer to expiration the faster time decay affects the options value. However, not all options are affected by time decay the same.

Some options are made up of intrinsic and extrinsic value while others are made up entirely of extrinsic value. Intrinsic value is the amount of real value, or the amount in-the-money an option is. Extrinsic value is the premium, or rent, you pay for owning an option, it is also called time-value. Out-of-the money options only have extrinsic value and are the options you will most likely be focusing on in your covered call writing. In-the-money options have a mix of intrinsic and extrinsic value.

Time decay only affects the extrinsic value of an option; the intrinsic value will always be there and never decays. Because OTM options only have extrinsic (time) value and no intrinsic value they lose value much quicker than ITM options.

Volatility And Trading Covered Calls

Volatility is an important aspect of trading covered calls. If you have not begun learning about this option metric now is the time to start. Without a working knowledge of how it works you can easily get caught in a poor covered call trade.

Volatility, among several other factors, is a very important influence on the price of options but what exactly is it? Volatility measures the amount of price movement we can expect from a stock based on its trading history. It does not matter if the price movement is up or down, volatility just measure the amount of movement. The more a stock is likely to move the higher the volatility. The less a stock is likely to move the lower the volatility. Volatility levels are important because the higher the volatility in a stock the more you will pay, or receive, for an option. Likewise, the more volatility a stock has the more you risk you take on as the seller of options.

Option volatility is measured in two ways, implied and historical. Implied volatility is a measure of how much the market expects a stock will move, based on the prices being paid for options at the current time. Historical volatility is a measure of the actual volatility of a stock over time. For the best premiums look for options with high implied volatility compared to the Historical Volatility. What this means for options sellers is that the options are “over priced” and trading for more than they should be, based on the stocks historical volatility. When options are overpriced sellers receive higher options premiums.

How You Trade A Covered Call

There are two basic strategies for trading covered calls. These are called buy-writes and legging-in. Both strategies can be applied to your trading in a variety of ways, depending on what your goals are.

  • Buy-writes are when you buy the underlying stock and sell the off-setting option position at the same time. This feature is available on most options trading platforms and is very useful when used in conjunction with a limit order for the pair.
  • Legging-in includes the same stock/option combination but instead of buying them both at the same time as in the buy-write scenario you make each trade, or leg, separately. First you buy the long stock position, then, after it has risen in value, you sell the short option position.

Legging-In Is The Best Way To Maximize Your Covered Call Returns

Legging-in to a covered call trade is the same as for a buy write except that you do not sell the option at the same time you buy the stock. Traders using this twist on the covered call strategy are trying to maximize their returns by buying the stock at a low price and then selling the option when it reaches a high price. This strategy can be applied to range bound as well as up trending stocks because it seeks to ride out dips and pullbacks in prices.

Example Of A Buy Write Order

This is the covered call or buy-write screen offered by OptionsXpress.  It allows you to enter the covered call as one trade.  This trade on Ford would return @ 3.5% if called out.
This is the covered call or buy-write screen offered by OptionsXpress. It allows you to enter the covered call as one trade. This trade on Ford would return @ 3.5% if called out. | Source

Steps For Trading Covered Call Buy-Writes

  • Fundamental Analysis – Choose a good stock with a solid reputation but no expectations for positive surprises. Likewise, there should also not be any expectations for negative surprises, if you are overly bullish or bearish on the stock it is not a good choice for covered call writing.

  • Technical Analysis- The technical analysis should be neutral to bullish. Again, no down trending stocks or stocks that are about to break out, they are not a good choice for this strategy. If the stock is trending sideways or within a trading range that is good.

  • Option Chain- Review the options chain to determine which option you want to sell. Consider volatility, strike price and theta when making the decision. For best results options that are at or near the money with 20-50 days until expiration have the highest volatility and the highest theta.

  • Calculate Risk/Reward- Use the equations provided above to calculate the expected return and the break even point. If these fit your trading profile and money management system then you can proceed. I recommend that you only enter a covered call trade if the return is at least 5% when called out. With practice it is easy to achieve monthly returns as high as 10-20% using covered calls.

  • Make the trade. Place a limit order for the combination position.

  • Monitor - keep an eye on the trade and exit if needed. This is usually only required if the stock falls below your break-even point or you become bearish on it.

Covered Calls Are A Synthetic Short Put

Covered calls are sometimes referred to as a short put because the risk/reward profile mimics the results of selling a put. To recap, one result of selling a covered call is that you own the stock, but at a price off-set by the call option premium. One result of a short put position is the same thing. Here's how it works:

  • By selling a short put you are granting someone the right to sell you a stock at a certain price and taking on the risk of that position in return for an option premium.

  • If the stock should fall below the strike price you will have to buy it at the strike price, in essence “putting” it back to the higher price.

  • When you buy it back your cost basis is the strike price minus the option premium and looks like this Cost Basis = Strike Price(Purchase Price) – Option Premium

Look familiar, it should. This is the same cost basis as a covered call. The cost basis there looks like this Cost Basis = Purchase Price – Option Premium. Now I'm sure you can understand why a covered call is called a synthetic short put.

The risk of the two positions is also essentially the same. In a covered call you are risking the cost of the underlying stock, it is limited to 100% of your cost basis. In a short put you are risking 100% of the potential cost basis should the stock go to zero. The main differences in trading the short put versus the covered call lie in your outlook on the stock and your trading level. It requires a minimum level 3 clearance to trade a short put. This is because of the nature of the derivative trade and the inherent risks of options trading.

Once you're cleared for trading short puts your outlook on the stock is the biggest determining factor on whether you should trade a short put or a covered call. If you are neutral to bullish on a stock and don't mind owning it and also don't mind selling it at a profit the covered call is the trade for you. If you are neutral to bullish on a stock and don't mind owning it at a lower cost basis but also don't care to buy it out right then selling short puts is the trade you want.

What To Expect From Covered Call Trading

Covered calls, like all trades, need to be monitored because you do not want to lose more than your calculated risk. There are several things that can happen to your covered call trade during the time you own it that may influence your decisions. Knowing what to expect can be a big help in planning potential exits for the trade.

Remember, no matter what, if the stock price is above the strike price of the option you have sold you will earn the maximum return.

  • What if volatility rises while I am in a covered call trade? If volatility rises, and the price of the underlying remains the same, then the value of the options will rise as well. If this happens your account could show a loss on the sale of the options. Do not panic, it is OK, this is just a theoretical loss of profits you could have received if you had waited to sell the option. Nothing about your trade has changed, your cost basis and risk/reward profile are still the same.

  • What if volatility decreases? If volatility decreases and the price of the underlying remains the same then the value of the options will decrease as well. This means you may be able to buy back the options at a profit sooner than expiration day and free up your capital for another trade.

  • What if the underlying stock increases in value? If the underlying increases in value then the options will also increase in value. Once again, your account may show a loss on the short option position but this is just a theoretical loss and a reminder of what you could have made if you had waited to sell the option.

  • What if the underlying decreases in value? If the underlying decreases in value you are OK so long as the price does not fall below your break-even point. The price of the option will also decrease and you may be able to buy it back at a nice profit earlier than expiration. If the stock looks like it is going to move below the break even point or you become overly bearish you may need to close the trade.

  • What if my covered call closes in the money? If your covered call closes in the money you will make the maximum profit for the trade. You will also be required to sell your stock to the owner of the call. Do not worry though, you will not have to do anything. Your broker is also a clearing house and will handle the transaction for you.

  • What if my covered call closes out of the money? If your covered call closes out of the money then the call will expire worthless. If this happens you get to keep the option premium and the underlying stock. At this point you can either sell the stock or trade another covered call and earn another option premium.

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