Options Trading

Definition of Covered Calls

This is an options trading technique in which you own underlying stock, then sell (write) call options at a higher strike price at an equivalent amount to your stock position. Because selling a call option gives the buyer the right to buy 100 shares of the stock from you at the strike price, you must own 100 shares of stock per option in order for this trade to be a covered call. It's "covered" because you already own the shares necessary to complete the option's requirements.

Why Trade Covered Calls?

Covered calls are a good way to earn income from a long-term stock position. When you sell the option you immediately collect that premium. You are selling an out-of-the-money call option, which puts the odds in your favor that it will expire worthless, and you will keep the full premium you collected. You needed the stock in order to be able to sell the call in the first place, so this premium you've collected can be considered income earned off of that stock.

Risks

First, let's explain what the normal risks are with a short call position. When you sell a call you are giving the buyer of that call the right, but not the obligation, to buy 100 shares of the stock from you at the strike price. Theoretically, this leaves you open to unlimited upside risk. For example, let's say XYZ stock is trading at $9.00 and you sell a $10 call. On the option's expiration day they announce that they have cured cancer. The stock shoots up to $500 instantly. The buyer of your call option now gets to exercise that option and buy 100 shares of stock from you for $10/share. You can expect a phone call from your brokerage asking you for a $49,000 deposit to your account, immediately.

However, because the short call in this case is covered by stock you already own, there is no big unlimited risk with this trading style. The risk comes in the form of opportunity risk.

Continuing with the above example, let's say you had already owned 100 shares of the stock that you bought at $9. You then sold the $10 call for $1, creating a covered call position. When the stock skyrockets to $500 your profit on the stock was capped once it hit $10. Every dollar that the stock price increased would create an offsetting loss on your short call. So, the opportunity cost was $490/share (minus the $1 you collected for selling the call).

This is an extreme example used to make a point. We'll explain a more real world situation below.

covered call

Example

Let's take a look at an example, and walk through what will happen with different stock price movements.

Covered Calls

In the option chain above we see:

  • LCID stock
  • Current stock price ask $40.54
  • Options expiring in 14 days
  • Implied Volatility of 104%
  • $43 calls (out-of-the-money) at $1.76
  • Covered Call Net Debit Price of $38.78

The Trade

With the covered call strategy trade you Buy 100 shares of LCID stock, and SELL 1 $43 call. You pay $40.54 for the shares, and you collect $1.76 for the call, meaning you pay a net debit of $38.78.

$38.78 now represents your break-even price on the stock you own. The explanation for this will be made clearer below.

Covered Call

Scenario #1 LCID stock climbs to $42.00

Over the next two weeks LCID stock bounces around a bit, then closes at $42.00 on expiration Friday. This means that you've so far made a profit of $1.46/share on your stock. Additionally, because the stock closed below your $43 call strike price, you have collected the full $1.76 for the now expired call.

You still own the shares of LCID stock, and as of now you have a profit of $3.22.

Scenario #2 LCID stock falls to $38.00

This time LCID stock spends two weeks dropping, ending up closing on expiration Friday at a price of $38.00. This means that you've lost $2.54/share on your long stock position. On the plus side, the short call that you sold for $1.76 expired out-of-the-money (meaning it closed below the strike price). You've therefore collected the full amount as profit.

You still own the shares of LCID stock, and as of now you have a loss of .78 cents/share.

Scenario #3 LCID stock climbs to $48.00

LCID stock soars, climbing all the way to $48.00, which blows through your short $43 strike. In this scenario, at expiration on Friday, you have a profit of $7.46/share on your stock, but a loss of $3.24 on the expired $43 call ($48.00 - $43.00 + $1.76 = $3.24).

In this situation, because the call expired in-the-money, the option would be exercised and would cancel out your 100 shares. You'd now own no shares of LCID, and would have booked a profit of $4.22.

Reality

Covered call scenarios are always written out as if you will simply hold your position right through expiration, and whatever happens then, happens. This is done for the convenience of clarity and calculation. In reality, this is not how a covered call trade ends. Assuming that you intend to continue to hold your stock position, you will always close the option before expiration.

A couple of likely scenarios:

If the stock falls, as you near expiration you're going to find that the majority of the potential premium for your short call has already been taken. Maybe the call you sold for $1.76 is now trading for just .20 with five days remaining until expiration. At that point, the reward-to-risk of continuing to hold that short call is likely quite poor. What you'd do in this case is "roll" that call to an expiration further away. You would buy your short call back for .20, and sell a different call expiring at a later date for more money. This is how you slowly pay for the shares you own.

Another scenario is that the stock climbs up beyond your strike price. If you want to keep your shares, you will need to close that call before expiration or you will have it exercised against you, canceling out your stock. Again, you would buy that call back and sell a new call further out, and at a higher strike price. You will have lost money on that initial short call, but made more money off of the rallying stock.

Conclusion

Covered calls are a low risk, low return way of lowering the cost of shares that you already own. The only risk this trade contains is in limiting your potential upside in the stock. It takes some active management, but is certainly a viable way to slowly accumulate gains on a stock that you intend to hold long-term anyway. I find that it is also a good way to enter a stock that you are interested in, but which may be a bit farther away from a good stop level than you are comfortable with.

Every case is different, but as a rule of thumb you should look for a call option that is trading around 50% or higher implied volatility, with anywhere from 2-4 weeks until expiration.

Lastly, if you intend to keep your shares of stock, be sure and close the call before expiration if the stock price has climbed above the strike price, otherwise your shares will be called away.