The Covered Call option strategy is one of the most basic and widely used options strategies. It is a great strategy for beginners and experienced options traders alike. The Covered Call is a very popular options strategy because it is relatively simple to implement and offers a high degree of protection.
In this article we are going to cover :
What is a Covered Call?
What are the advantages of a Covered Call?
When to use a Covered Call?
How do we manage a Covered Call?
How do we put on a Covered Call?
And we will show you using a real example on the TastyWorks Option Trading Platform.
Let’s jump right into it.
What is a Covered Call?
A Covered Call is an options strategy where you buy shares of stock and then sell call options on those same shares.
The Covered Call is a bullish strategy because you are expecting the stock price to go up. When it goes up you profit!
What are the advantages of a Covered Call?
There are a few advantages of a Covered Call.
The first advantage is that it offers protection in case the stock price goes down. If the stock price goes down, you will still make money because you sold the call option.
The second advantage is that you make money if the stock price goes up. If the stock price goes up, you will make money from the stock price going up. You will also make money from the call option that you sold if the price stays below the strike price of the call option that you sold.
If the stock price goes up beyond your call strike price then your stock is just called away and you still make a profit.
Another advantage of the Covered Call is that it can provide a steady stream of income.
If you are long a stock and it is not moving, selling Covered Calls can help you to generate income while you wait for the stock to move.
Now let’s talk about when to use a Covered Call.
When should a Covered Call be used?
A Covered Call can be used in several different situations.
It is a good strategy to use when you own a stock that is not moving and you want to generate income from the option premium. You may not want to sell the particular stock to stay off capital gains and qualify for the long-term capital gains treatment after holding it for 1 year.
Another situation where the Covered Call can be used is when you are selling a stock and want to generate income to offset the capital gains tax.
Lastly, if you are using the Option Wheel Strategy and are assigned a stock, then you can write a call option against it to generate income while you wait for it to be called away.
What are the downsides to a Covered Call?
The Covered Call is a relatively safe strategy, but there are some downsides.
First, if the stock price goes up too much you will miss out on additional profits. This is because your shares will be called away at the strike price of the call option.
Second, if the stock price goes down you will lose money on your shares. However, you will offset some of this loss with the option premium that you received when you sold the Covered Call.
Now that we know what a Covered Call is and when to use it, let’s look at how to put one on.
How do we put on a Covered Call?
Writing a Covered Call is relatively simple. Covered Calls are written against shares that you already own. If you don’t own the shares, then you can buy them first and then write the Covered Call.
To write a Covered Call, you will need to find a stock that you want to write a Covered Call against. You want to pick a stock that you are bullish on and believe will go up in price.
Once you have found the stock, you will purchase a contract which is 100 shares of the stock. The strike price is the price at which the buyer of the option can purchase the shares from you.
The expiration date is the date at which the option expires. I suggest selecting the date that is closest to around 45 days to expiration. We pick this expiration date to maximize profit and minimize risk.
You will then sell one call option contract for every 100 shares of stock that you own. For example, if you own 1000 shares of Apple stock, you would sell 10 call option contracts.
That’s it! You are now short a Covered Call.
If you are assigned, the buyer of your call option will purchase your shares at the strike price and you will exit the trade. If you are not assigned, then you still own the shares and can choose to sell them at any time.
How Do We Manage A Covered Call?
We roll a covered call when our assumption remains the same (that the price of the stock will continue to rise). We look to roll the short call when there is little to no extrinsic value left. For instance, if the stock price remains roughly the same as when we executed the trade, we can roll the short call by buying back our short option and selling another call on the same strike in a further out expiration.
We will also roll our call down if the stock price drops. This allows us to collect more premium and reduce our max loss & breakeven point. We are always cognizant of our current breakeven point, and we do not roll our call down further than that. Doing so can lock in a loss if the stock price comes back up and leaves our call ITM.
When do we close covered calls?
We close covered calls when the stock price has gone well past our short call, as that usually yields close to max profit. We may also consider closing a covered call if the stock price drops significantly and our assumption changes.
How Do We Lose With A Covered Call?
This Covered Call all sounds too good to be true right?
However, there are some potential drawbacks to this strategy.
The Covered Call will limit your upside potential in the stock. This is because you are not only long the shares, you are also short a call. So if the price of the stock goes up too much, your call will get exercised and you will be forced to sell your shares at the strike price.
The other way that we lose with a covered call is if the stock moves down in price. Just like buying the 100 shares outright, the stock can go to zero. So we still need to be careful and only buy stocks that we think will increase in price.
Covered Call Example
To better understand how the Covered Call works, let’s look at an example.
We are going to put on a Covered Call in SNAP. We will use the TastyWorks Trade platform. By the way I’ll put the link in the notes below if you want to open an account and get the free stock promotion. It is the option trade platform that I use most of the time and I think it’s the best for trading options.
So we are going to go to the trade tab and punch in the ticker SNAP up above. I like to use the curve mode so that I can visually see the profit zone in green.
We go to the strategy tab and hit short covered call and go. The TastyWorks platform will automatically set you up to purchase 100 shares of the stock and sell a out of the money call.
In this case we are buying 100 shares at 33.77 and selling a 35 strike call with 35 days to expiration and collecting 3.10.
Our cost is $3065 since the $310 we are collecting from call brings down our cost basis by that amount. Normally in order to by 100 shares of stock at 33.77 will cost 3,377. However, you can see from the BP effect which is buying power we are only required to put up $1375. So it is very cost efficient way of investing and safer than just buying the 100 shares of stock outright since you are also collecting the $310. on the call side.
Now if you look at the green area which is the P&L at expiration, we dont start losing money until the stock moves down to just below 31. So if it stays where it is at or even moves down a little we still profit.
If the stock moves up in price, which is what we are hoping for, then we profit as well. The max profit as you can see if $435 which occurs if the stock reaches $35 or higher by the expiration date in 36 days.
Conclusion
The covered call is a great way to generate income on your stock holdings as well as increase profit and reduce risk.
The covered call is also a part of one of the best strategies for beginners The Option Wheel Strategy. I’ll put a link down below to a free training and guide that covers that strategy.
Lastly, always do your research and consider your investment goals before you begin trading stock options. For more stock and financial information, please check out our other resources at OptionsFinanceProfits.com.
