Covered call option trading strategy

How and Why to Use a Covered Call Option Strategy.

The risks and reward of using Covered Calls.

A covered call is an options strategy that involves both stock and an options contract. The trader buys (or already owns) a stock, then sells call options for the same amount (or less) of stock, and then waits for the options contract to be exercised or to expire.

If the options contract is exercised (at any time for US options, and at expiration for European options) the trader will sell the stock at the strike price, and if the options contract is not exercised the trader will keep the stock.

For a covered call, the call that is sold is typically out of the money (OTM). This allows for profit to be made on both the options contract and the stock if the stock price stays below the strike price of the OTM option. If you believe the stock price is going to drop, but you still want to maintain your stock position for the time being, you can sell an in the money call option (ITM). For this you will receive a higher premium on your option trade, but the stock must fall below the ITM option strike price, otherwise the buyer of your option will receive your shares if the share price is above the strike price at expiration (you lose your share position). This is discussed in more detail in the Risk and Reward section below.

How to Create a Covered Call Trade.

Purchase a stock, and only buy it in lots of 100 shares. Sell a call contract for each 100 shares of stock you own. One contract represents 100 shares of stock. If you own 500 shares of stock, you can sell up to 5 call contracts against that position. You can also sell less than 5 contracts, which means if the call options are exercised you will retain part of your stock position. In this example, if you sell 3 contracts, and the price is above the strike price at expiration, 300 of your shares will be called away, but you will still have 200 remaining. Wait for the call to be exercised or to expire. You are making money off the premium the buyer of the option is paying you. If the premium is $0.10 per share, you make that full premium if you hold option until expiration and it is not exercised. You can buy back the option before expiry, but there is little reason to do so, and thus isn't usually part of the strategy.

Risks and Rewards of the Covered Call Options Strategy.

As shown on the risk/reward chart (view the full size chart), the risk of a covered call comes from holding the stock position, which could drop.

Your maximum loss occurs if the stock goes to zero. Therefore, you maximum loss per share is:

(Stock Entry Price - $0) + Option Premium Received.

For example, if you buy a stock at $9, and receive a $0.10 option premium on your sold call, your maximum loss is $8.90 per share. The option premium reduces your maximum loss, relative to just owning the stock. The income from the option premium comes at a cost though, as it also limits your upside on the stock.

You can only profit on the stock up to the strike price of the options contracts you sold. Therefore, your maximum profit is:

(Strike Price - Stock Entry Price) + Option Premium Received.

For example, if you buy a stock at $9, receive a $0.10 option premium from selling a $9.50 strike price call, then you maintain your stock position as long as the stock price stays below $9.50 at expiration. If the stock price moves to $10, you only profit up to $9.50, so your profit is $9.50 - $9.00 + $0.10 = $0.60.

If you sell an ITM call option, the price will need to fall below the strike price in order for you to maintain your shares.

If this occurs, you will likely be facing a loss on your stock position, but you will still own your shares, and you will have received the premium to help offset the loss.

Final Word on the Covered Call Options Strategy.

The main goal of the covered call is to collect income via option premiums by selling calls against a stock that is already owned. Assuming the stock doesn't move above the strike price, the trader collects the premium and is allowed to maintain the stock position (which can still profit up to the strike price).

Traders need to factor in commission when trading a covered call. If commissions will erase a significant portion of the premium received, then it isn't worth while selling the option(s) and creating a covered call.

Covered call writing is typically used by investors and longer-term traders, and is rarely used by day traders.

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Covered Calls.

The covered call is a strategy in options trading whereby call options are written against a holding of the underlying security.

Using the covered call option strategy, the investor gets to earn a premium writing calls while at the same time appreciate all benefits of underlying stock ownership, such as dividends and voting rights, unless he is assigned an exercise notice on the written call and is obligated to sell his shares.

However, the profit potential of covered call writing is limited as the investor had, in return for the premium, given up the chance to fully profit from a substantial rise in the price of the underlying asset.

Out-of-the-money Covered Call.

This is a covered call strategy where the moderately bullish investor sells out-of-the-money calls against a holding of the underlying shares. The OTM covered call is a popular strategy as the investor gets to collect premium while being able to enjoy capital gains (albeit limited) if the underlying stock rallies.

Limited Profit Potential.

In addition to the premium received for writing the call, the OTM covered call strategy's profit also includes a paper gain if the underlying stock price rises, up to the strike price of the call option sold.

The formula for calculating maximum profit is given below:

Max Profit = Premium Received - Purchase Price of Underlying + Strike Price of Short Call - Commissions Paid Max Profit Achieved When Price of Underlying >= Strike Price of Short Call.

Unlimited Loss Potential.

Potential losses for this strategy can be very large and occurs when the price of the underlying security falls. However, this risk is no different from that which the typical stockowner is exposed to. In fact, the covered call writer's loss is cushioned slightly by the premiums received for writing the calls.

The formula for calculating loss is given below:

Maximum Loss = Unlimited Loss Occurs When Price of Underlying The Options Guide.

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Covered Call.

What is a 'Covered Call'

A covered call is an options strategy whereby an investor holds a long position in an asset and writes (sells) call options on that same asset in an attempt to generate increased income from the asset. This is often employed when an investor has a short-term neutral view on the asset and for this reason holds the asset long and simultaneously has a short position via the option to generate income from the option premium. A covered call is also known as a "buy-write".

BREAKING DOWN 'Covered Call'

Maximum Profit and Loss.

The maximum profit of a covered call is equivalent to the strike price of the short call option less the purchase price of the underlying stock plus the premium received. Conversely, the maximum loss is equivalent to the purchase price of the underlying stock less the premium received.

Covered Call Example.

For example, let's say that you own shares of the hypothetical TSJ Sports Conglomerate and like its long-term prospects as well as its share price but feel in the shorter term the stock will likely trade relatively flat, perhaps within a few dollars of its current price of, say, $25. If you sell a call option on TSJ with a strike price of $26, you earn the premium from the option sale but cap your upside. One of three scenarios is going to play out:

a) TSJ shares trade flat (below the $26 strike price) - the option will expire worthless and you keep the premium from the option. In this case, by using the buy-write strategy you have successfully outperformed the stock.

b) TSJ shares fall - the option expires worthless, you keep the premium, and again you outperform the stock.

c) TSJ shares rise above $26 - the option is exercised, and your upside is capped at $26, plus the option premium. In this case, if the stock price goes higher than $26, plus the premium, your buy-write strategy has underperformed the TSJ shares.

To know more about covered calls and how to use them, read The Basics Of Covered Calls and Cut Down Option Risk With Covered Calls.

An Alternative Covered Call Options Trading Strategy.

Books about option trading have always presented the popular strategy known as the covered-call write as standard fare. But there is another version of the covered-call write that you may not know about. It involves writing (selling) in-the-money covered calls, and it offers traders two major advantages: much greater downside protection and a much larger potential profit range. Read on to find out how this strategy works.

Traditional Covered-Call Write.

At the time these prices were taken, RMBS was one of the best available stocks to write calls against, based on a screen for covered calls done after the close of trading. As you can see in Figure 1, it would be possible to sell a May 55 call for $2.45 ($245) against 100 shares of stock. This traditional write has upside profit potential up to the strike price, plus the premium collected by selling the option.

Figure 1 - RMBS May option prices with the May 25 in-the-money call option and downside protection highlighted.

The maximum return potential at the strike by expiration is 52.1%. But there is very little downside protection, and a strategy constructed this way really operates more like a long stock position than a premium collection strategy. Downside protection from the sold call offers only 6% of cushion, after which the stock position can experience un-hedged losses from further declines. Clearly, the risk/reward seems misplaced.

Alternative Covered Call Construction.

Looking at another example, a May 30 in-the-money call would yield a higher potential profit than the May 25. On that strike, there is $260 in time premium available.

As you can see in Figure 1, the most attractive feature of the writing approach is the downside protection of 38% (for the May 25 write). The stock can fall 38% and still not have a loss, and there is no risk on the upside. Therefore, we have a very wide potential profit zone extended to as low as 23.80 ($14.80 below the stock price). Any upside move produces a profit.

While there is less potential profit with this approach compared to the example of a traditional out-of-the-money call write given above, an in-the-money call write does offer a near delta neutral, pure time premium collection approach due to the high delta value on the in-the-money call option (very close to 100). While there is no room to profit from the movement of the stock, it is possible to profit regardless of the direction of the stock, since it is only decay-of-time premium that is the source of potential profit.

Also, the potential rate of return is higher than it might appear at first blush. This is because the cost basis is much lower due to the collection of $1,480 in option premium with the sale of the May 25 in-the-money call option.

Potential Return on in-the-Money Call Writes.

As you can see in Figure 2, with the May 25 in-the-money call write, the potential return on this strategy is +5% (maximum). This is calculated based on taking the premium received ($120) and dividing it by the cost basis ($2,380), which yields +5%. That may not sound like much, but recall that this is for a period of just 27 days. If used with margin to open a position of this type, returns have the potential to be much higher, but of course with additional risk. If we were to annualize this strategy and do in-the-money call writes regularly on stocks screened from the total population of potential covered-call writes, the potential return comes in at +69%. If you can live with less downside risk and you sold the May 30 call instead, the potential return rises to +9.5% (or +131% annualized) - or higher if executed with a margined account.

Figure 2 - RMBS May 25 in-the-money call write profit/loss.