Covered Calls - Enhance your stock portfolio

Covered Calls

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To execute a covered call, an investor holds a long position in an underlying asset, such as a stock, and sells call options on that asset to generate income. The investor already owns the underlying shares, allowing them to deliver the shares if the call options are exercised. By selling call options, the investor collects a premium from the buyer of the options. This premium provides a source of income for the investor, but it also limits their potential profit from the underlying shares. If the price of the underlying shares increases above the strike price of the call options, the investor must sell the shares at the strike price, missing out on potential gains. However, if the price of the underlying shares does not increase above the strike price, the investor can keep the premium and continue to hold the underlying shares.

Strategy

Selling the call obligates you to sell stock you already own at strike price A if the option is assigned.

Some investors will run this strategy after they’ve already seen nice gains on the stock. Often, they will sell out-of-the-money calls, so if the stock price goes up, they’re willing to part with the stock and take the profit.

Covered calls can also be used to achieve income on the stock above and beyond any dividends. The goal in that case is for the options to expire worthless.

If you buy the stock and sell the calls all at the same time, it’s called a ”Buy / Write.” Some investors use a Buy / Write as a way to lower the cost basis of a stock they’ve just purchased.

Example of a covered call:

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Selling a Call on QQQ

Suppose an investor owns 100 shares of ABC Corporation, which is currently trading at $50 per share. The investor believes that the stock is likely to remain at or near its current price over the next few months, but is looking for a way to generate some income from their investment. To do this, the investor decides to sell one call option on ABC Corporation with a strike price of $55 and an expiration date of three months from now. By selling this option, the investor receives a premium of $2 per share, for a total of $200 (100 shares x $2 premium).

If the price of ABC Corporation remains at or below $55 per share over the next three months, the call option will expire worthless and the investor will keep the $200 premium. However, if the price of the stock increases above $55 per share, the option will be exercised and the investor will be required to sell their shares at the strike price of $55. This means that the investor will miss out on any additional increase in the stock price above $55, but will still receive the $200 premium. Overall, the covered call strategy allows the investor to generate income from their investment in ABC Corporation, but also limits their potential profit if the stock price increases significantly.

Rolling covered calls

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When implementing the covered call strategy, it is important to be prepared for the possibility that the price of the underlying stock will reach the strike price of your call options. If this happens, you will be required to sell all of the shares you hold, which could result in a loss if the stock price has declined. However, there are a few options available to you if you do not want to be forced to sell your shares.

One option is to simply close the position for a loss. This means you will sell your call options and any remaining shares you hold, and take the loss. This is not a desirable outcome, but it is sometimes necessary to cut your losses and move on.

Another option is to roll the option to the next week, or to a later expiration date. This means you will sell your current call options and buy new options with a later expiration date. This effectively extends the time you have to wait before you are required to sell your shares. This can be a good option if you believe the stock price will continue to rise and you want to avoid being forced to sell your shares at a lower price. However, it is important to remember that rolling the option will also result in additional trading costs and potentially lower premiums, so it is not always the best option.

In our case below, I would buy back my previous option at a loss and sell a another new covered call a few days later at a higher strike price and collect a premium.

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Roll to next week

Options Rolls: Tools to Adjust Your Trading Strategy

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October 1, 2020 4 min read

Photo by Getty Images

You put a lot of thought into an options trade. Everything on your checklist is crossed off, and you’re confident the underlying will move in a particular direction. But then, things don’t go as you thought they would. You could close out your position or reduce your exposure to lessen the blow. But another alternative could be  rolling your options position.

Why would you roll an option? Perhaps you think buying more time will help generate a potential profit; maybe you want to avoid getting assigned; or perhaps the outlook of the underlying has changed and you want to try take advantage of it. Whatever the reason, rolling an options strategy means you’re adjusting your position to a further expiration and/or to a different strike price.

How to Roll Options

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As an example, let’s look at rolling covered calls.

Suppose you’re a covered call trader selling calls against long stock positions. But as expiration gets closer and the underlying is relatively flat, you worry that you might get assigned. Instead of waiting until expiration to find out, you might roll the short calls from one month to the next and choose a different strike price. By rolling a covered call, you’ll be closing out one position and opening another call contract.

You’re generally going to roll for two reasons. First, if the short call is in the money  (ITM), rolling the option could mean your stock may not be called away (although there’s always some risk of it being called away or assigned). Second, regardless of whether your option is set to expire ITM or  out of the money (OTM), rolling the option allows you to replace a position with little or no time value with an option that has time value. Typically, the more time value an option has, the greater the profit potential in your covered call position.

Of course, there’s more to it. You still don’t know with certainty how the underlying stock will perform over the next month. How soon should you start trying to roll? Which expiration date should you choose? Should you roll up (higher strike price) or down (lower strike price)? At what point might you switch from a limit order  to a  market order and wrap up the transaction?

That’s a long list of questions to deal with, especially in the midst of uncertainty. And that’s just for one stock. Think about the workload if that checklist applied to several options trades. Fortunately, there are tools that can take on some of the burden.

How to choose a strike price?

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To implement the covered call strategy, some investors target a specific delta value when choosing the strike price for their options. Delta is a measure of the sensitivity of an option’s price to changes in the price of the underlying asset. It is commonly used to gauge the likelihood that an option will be exercised. For example, an option with a delta of 0.25 has a 25% chance of being exercised, while an option with a delta of 0.50 has a 50% chance of being exercised.

When implementing the covered call strategy, some investors choose to target a delta value below or above 0.25 when selecting the strike price for their options. For example, an investor might choose to sell a call option with a delta of 0.20, indicating a 20% chance of being exercised. This approach can help investors manage their risk and select options that are more likely to expire worthless. Additionally, some online brokerage platforms, such as Robinhood, provide a “Chance of Profit” column that derives its probability from the delta value, which can make it easier for investors to choose options with the desired level of risk.

How much money is needed?

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To sell call options in a covered call strategy, you need to have enough money in your brokerage account to cover the cost of buying the underlying shares if the call options are exercised. The amount of money you need depends on factors such as the number of shares you are planning to sell call options on, the current price of the underlying shares, and the strike price of the options.

For example, if you are planning to sell call options on 100 shares of a stock that is currently trading at $100 per share, you will need to have at least $10,000 in your account to cover the cost of buying the shares if the options are exercised. This is because each call option contract covers 100 shares, and the cost of buying 100 shares at $100 per share is $10,000. Similarly, if you are planning to sell call options with a strike price of $110, you will need to have at least $11,000 in your account to cover the cost of buying the shares if the options are exercised.

It is important to note that you will not be able to access the money you have set aside to cover the cost of buying the underlying shares if the call options are exercised. This money will be “blocked” in your account until the options expire or are sold. Therefore, you should only use money for covered calls that you are comfortable not having access to for a period of time.

When to do covered calls?

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You’re neutral to bullish, and you’re willing to sell stock if it reaches a specific price.

Sweet Spot

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The sweet spot for this strategy depends on your objective. If you are selling covered calls to earn income on your stock, then you want the stock to remain as close to the strike price as possible without going above it.

If you want to sell the stock while making additional profit by selling the calls, then you want the stock to rise above the strike price and stay there at expiration. That way, the calls will be assigned.

However, you probably don’t want the stock to shoot too high, or you might be a bit disappointed that you parted with it. But don’t fret if that happens. You still made out all right on the stock. Do yourself a favor and stop getting quotes on it.

The covered call strategy can potentially be more profitable than selling cash secured puts for several reasons. First, covered calls often have higher premiums because the investor is taking on more risk. When selling a cash secured put, the investor agrees to buy the underlying stock at a predetermined price. If the stock price declines, the investor can buy the stock at a lower price and potentially profit. However, if the stock price increases, the investor must buy the stock at a higher price and potentially incur a loss.

In contrast, when selling a covered call, the investor agrees to sell the underlying stock at a predetermined price. If the stock price increases, the investor can sell the stock at a higher price and potentially profit. However, if the stock price declines, the investor must sell the stock at a lower price and potentially incur a loss. Because the investor takes on more risk when selling a covered call, they can typically collect a higher premium than when selling a cash secured put.

Another reason selling covered calls may be more profitable is that it allows the investor to benefit from potential stock appreciation. When selling cash secured puts, the investor agrees to buy the stock at a predetermined price. If the stock price increases, the investor misses out on potential profit from the stock appreciation because they must buy the stock at the predetermined price. In contrast, when selling covered calls, the investor can benefit from potential stock appreciation because they can sell the stock at the higher price if the option is exercised.

Overall, selling covered calls can be more profitable than selling cash secured puts because it allows the investor to collect a higher premium and benefit from potential stock appreciation. However, it is important to remember that both strategies carry risks and it is important to carefully consider the potential risks and rewards before implementing either

Selling covered calls on longterm holdings

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Selling covered calls on long-term holdings can generate additional income from your investment portfolio. When you sell covered calls, you agree to sell the underlying stock at a predetermined price (the strike price) if the option is exercised. If the stock price increases above the strike price, the option will likely be exercised, you keep the premium and you must sell your stock at the predetermined price. However, if the stock price remains below the strike price, the option will expire worthless and you can keep the premium you received from selling the call option.

Selling covered calls on long-term holdings can be a good strategy because it allows you to generate income from your stock holdings without selling the underlying shares. This can be especially beneficial if you have stocks you want to hold for the long term but also want to generate income from your portfolio. By selling covered calls on your long-term holdings, you can collect a premium from the option sale without missing out on future stock price appreciation.

However, it is important to carefully consider the risks and rewards of selling covered calls on long-term holdings. In some cases, the stock price may increase above the strike price and you must sell your shares at the predetermined price, resulting in a loss if the stock price continues to rise. Additionally, selling covered calls on long-term holdings can have tax implications, so consult with a financial advisor or tax professional before implementing this strategy.

What is the risk?

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The main risk of selling covered calls is that the stock price may increase above the strike price, requiring you to sell your shares at the predetermined price. If the stock price continues to rise, you may miss out on potential profits. Additionally, if the stock price declines significantly, you may incur a loss on the sale of your shares.

Another potential risk is that the stock may not perform as well as expected, resulting in a lower premium for the option. This can reduce the potential profit from the covered call strategy. Additionally, there may be additional trading costs associated with selling covered calls, further reducing potential profits.”

Tips

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As a general rule of thumb, you may wish to consider running this strategy approximately 30-45 days from expiration to take advantage of accelerating time decay as expiration approaches. Of course, this depends on the underlying stock and market conditions such as implied volatility.

You may wish to consider selling the call with a premium that represents at least 2% of the current stock price (premium ÷ stock price). But ultimately, it’s up to you what premium will make running this strategy worth your while.

Beware of receiving too much time value. If the premium seems abnormally high, there’s usually a reason for it. Check for news in the marketplace that may affect the price of the stock. Remember, if something seems too good to be true, it usually is.

Uncovering the Covered Call: An Options Strategy for Potentially Enhancing Portfolio Returns

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June 16, 2022 7 min read

Photo by TD Ameritrade

The covered call  is one of the most straightforward and widely used options-based strategies for investors who want to pursue an income goal as a way to potentially enhance returns. In fact, traders and investors may even consider covered calls in their IRAs. It’s a pretty basic and straightforward options strategy, but there are some things you need to know.

Covered Calls Explained

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First, let’s nail down a definition. A covered call is a neutral to bullish strategy where a trader sells one out-of-the-money (OTM) or at-the-money (ATM) call options contract for every 100 shares of stock owned, collects the premium, and then waits to see if the call is exercised or expires. Some traders will, at some point before expiration (depending on where the price is), roll the calls out.

To create a covered call, a trader sells an OTM call against stock they own. If it expires OTM, the trader keeps the stock and maybe sells another call in a further-out expiration. The trader can keep doing this unless the stock moves above the strike price of the call. When that happens, the trader can either let the in-the-money (ITM) call be assigned and deliver the long shares, or buy the short call back before expiration, potentially taking a loss on that call, and keep the stock. Keep in mind, short options can be assigned at any time up to expiration regardless of the ITM amount.

Traditionally, the covered call strategy has been used to pursue two goals:

1. For most traders, generate income
2. For a much smaller number of traders, offset a portion of a stock’s potential price drop

Generate income.We’ll look at a basic covered call example. Say a trader owns 100 shares of XYZ Corp., which is trading around $32. There are several strike prices for each expiration month (see figure 1). For now, let’s look at the calls that are OTM, that is, the strike prices are higher than the current price of the underlying stock. If the call is assigned and the stock is sold at the strike price, it might as well sell it at a higher price, right?

Some traders take the OTM approach in hopes of the lower odds of seeing the stock called away. Others get calls closer to the stock price, or ATM, to try get a larger credit for the calls.

FIGURE 1: STRIKE SELECTION. From the  Analyze tab, enter the stock symbol, expand the Option Chain, and analyze the various options expirations and the out-of-the-money call options within the expirations. Source: the  thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.

As long as the stock price remains below the strike price through expiration, the option will likely expire worthless. Options are subject to “time decay,” meaning they usually decrease in value in the days and weeks to come (all other factors being equal). This typically works in favor of the option seller.

A trader might consider selling a 37-strike call (one options contract typically specifies 100 shares of the underlying stock). The trader runs the “risk” of having to sell the stock for $5 more than the current price, so they should be comfortable with that prospect before entering the trade. But they’ll immediately collect $1.85 per share ($185) minus transaction costs. That’s in addition to whatever the stock may return during this time frame. If the call expires OTM, they could consider selling another call at a further out expiration date.

Keep in mind that the price for which a trader can sell an OTM call is not necessarily the same from one expiration to the next, mainly because of changes in implied volatility  (vol). When vol is higher, the credit a trader takes in from selling the call could be higher as well. But when vol is lower, the credit for the call could be lower, as is the potential income from that covered call.

Please note: This explanation only describes how a position makes or loses money. It doesn’t include transaction fees, and it may not apply to the tax treatment of your position.

Rolling Your Calls

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To “roll” a call is to buy back your short call and sell an expiration further out in time, while leaving your stock position alone. One way to do this is to go to the Monitor tab on the thinkorswim platform  and select  Strategy Roller. Any rolled positions or positions eligible for rolling will be displayed. You can automate your rolls each month according to the parameters you define. For more information, visit the  thinkorswim Learning Center and search for “Strategy Roller.”

Offsetting a portion of a stock price’s drop. A covered call can compensate to some degree if the stock price drops, the short call expires OTM, and the short call’s profit offsets the long stock’s loss. But if the stock drops more than the call price, the covered call strategy can begin to lose money. In fact, the covered call’s maximum possible loss is the price at which the stock was purchased minus the credit(s) from short calls plus transaction costs. The bottom line? If the stock price tanks, the short call offers minimal protection.

Select Strikes Accordingly

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Notice that this all hinges on whether the trader gets assigned, so they need to select the strike price strategically.

If a stock’s been beaten down and a trader thinks a rally is in order, they might decide to forgo the covered call. Even though they may be able to buy back the short call to close it before expiration (or possibly make an adjustment), if they think the stock’s ready for a big move to the upside, it might be better to wait. Conversely, if the underlying had a big run and a trader thinks it’s out of steam, then they might more aggressively pursue a covered call.

Once a trader is ready to pull the trigger, what strike should they choose? There’s no right answer to this, but here are some ideas to consider:

• Select a strike where one is comfortable selling the stock. This is about as old school as it can get.
• Choose a strike price where there’s resistance on the chart. If the stock hits that resistance level and holds steady until expiration, the trade may have hit its full profit potential for that expiration period.
• Pick a strike based on its probability of being ITM at expiration  by looking at the  delta  of the option. For example, a call with a 0.25 delta is read by some traders to imply there’s a 25% chance of it being  above  the strike and a 75% chance of it being  below the strike at expiration. It’s not exact, of course, but some consider it a rough estimate.

Weighing the Risks vs. Benefits

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A trader might be giving up the potential for hitting a home run if XYZ rockets above the strike price, so covered calls may not be appropriate if one thinks the stock is going to shoot the moon. But in markets that’re moving more incrementally, this strategy could be beneficial. Keep in mind that if the stock goes up, the call option sold also increases in value. But that’s part of the risk with this options-based income strategy.

What happens when a trader holds a covered call until expiration? First, if the stock price goes above the strike price, the stock will most likely be called away, perhaps netting an overall profit if the strike price is higher than where the stock was purchased. Second, if the stock price moves up near the strike price at expiration, the trader would likely get to keep the stock and have the gain from keeping the full premium of the now-worthless option.

A covered call has some limits for equity investors and traders because the profits from the stock are capped at the strike price of the option. Another downside here is the chance of losing a stock a trader wanted to keep. Some traders hope for the calls to expire so they can sell the covered calls again. Others are concerned that if they sell calls and the stock runs up dramatically, they could miss the up move.

Covered calls, like all trades, are a study in risk versus return. With the tools available at one’s fingertips, traders could consider covered call options strategies to potentially generate income.

Selling covered calls – an underrated and often misunderstood trading strategy

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Discussion

I recently commented on a post about GME that I sell covered calls (henceforth CCs) on meme stocks. The reception to the comment was poor – 35 downvotes and counting. Upon reviewing responses to my comment, I realized that many people have a fundamental misunderstanding of CCs. I hope to clear some of those up and introduce in what may be a new strategy to those who read this.

What does it mean to sell covered calls?

To sell a covered call means to buy 100 shares of a stock and then sell a call option against the shares. When you sell the call, you collect a premium upfront. If the underlying stock is above the strike price on the expiry date, you will get assigned. Since you are “covered” and own 100 shares of the underlying, you can deliver your shares to the holder of the call to satisfy your obligation. If the stock is below the strike price on the expiry date, you get to keep the shares. In either situation, the premium is yours to keep.

This strategy is different than selling a naked call option (i.e., selling a call without owning the underlying). In that strategy, you lose $1 for every cent the stock is above the strike price at expiry. With CCs, you own 100 shares of the stock, so those 100 shares were also able to make $1 for every cent in price appreciation. In essence, with CCs you are selling the upside above the strike price to the long of the trade.

Three strategies compared under four scenarios

The best way to demonstrate why I believe this strategy is so valuable is to compare trading outcomes under four strategies – selling covered calls, owning 100 shares outright, and owning a call option.

For this example, I will use AMC shares which last traded at $54.23 and a 55 strike July 2 expiry call which last traded at $4.25. This example is for AMC, but this can be done with any stock if you substitute the applicable pricing.

If this is too much reading, I’ve summarized what I believe is the best trading strategy in each price band within the chart below.

Trading strategies compared

Scenario 1 – AMC goes down (Winner: tie between selling covered calls and owning a call)

• Selling covered calls: The shares will lose money; however, because you collected a premium, you are still ahead if AMC finishes above $49.98 ($54.23-$4.25). Even if AMC finishes below $49.98, you can “roll” your option to a different expiry and collect more premium.
• Owning 100 shares outright: The shares will lose money.
• Owning a call: The call finishes out of the money and your loss is the premium paid of $425. I am giving this one a tie because if the stock tanks, the call has a 100% loss but in dollar terms the loss is limited. So in a sense the winner depends on how much the stock falls and if you believe the stock will recover in the future.

Scenario 2 – AMC stays at $54.23 (Winner: selling covered calls)

• Selling covered calls: The shares neither make nor lose money; however, you profit the premium received of $425. Since $54.23 is below the strike of $55, you can roll the option to a different expiry and collect more premium.
• Owning 100 shares outright: The shares neither make nor lose money.
• Owning a call: The call finishes out of the money and your loss is the premium paid of $425.

Scenario 3 – AMC finishes in the range of $55-$59.25 (Winner: tie between selling covered calls and owning 100 shares outright)

• Selling covered calls: The shares participate in the upside up until $55. This would mean a $77 profit on the shares (\[$55-$54.23\] x 100). You would also keep the premium of $425 which brings the total profit to $502. You would lose the shares as the stock finished above $55.
• Owning 100 shares outright: The shares will gain money. Your profit would be the difference in the finishing price and $54.23, all multiplied by $100. So, if AMC finishes at $59.25, the profit would be $502 (\[$59.25-$54.23\] x 100).
• Owning a call: The call finishes in the money; however, since you had to pay a premium, that must be subtracted from the gain. If the stock finishes at $59.25, you would breakeven (\[$59.25-$55-$4.25\] x 100).

Scenario 4 – AMC finishes above $59.68 (Winner: owning a call)

• Selling covered calls: Same as scenario 3. The profit is $502 and you lose your shares.
• Owning 100 shares outright: The shares will gain money. Your profit would be the difference in the finishing price and $54.23, all multiplied by $100. If the stock finishes at $59.68, your profit would be $545.
• Owning a call: The call finishes in the money; however, since you had to pay a premium, that must be subtracted from the gain. If the stock finishes at $59.68, your profit would be $42.69 (\[$59.68-$55-$4.25\] x 100). As a percentage of the original investment, this strategy has a higher ROI than owning 100 shares outright for stock prices above $59.68.

There are a few gaps in these scenarios, but the point should be clear by now. Selling covered calls is profitable in scenarios 2-4 and in scenario 1 if the stock is above $49.98. Owning 100 shares is profitable in scenarios 3 and 4 while owning a call was profitable in only scenario 4.

This is why I love selling covered calls – it is profitable in more market conditions than the other trading strategies. It will outperform other strategies unless the underlying stock makes a large move to the upside.

Misconceptions

I came across a few misconceptions in responses to my comment. Here are a few of them.

You can’t make money on CCs if the stock goes up. – Absolutely you would. If the stock goes up, you get to keep the premium. Only in selling a naked call would you not make money in this situation.

You shouldn’t sell CCs on a high IV stock. – Assuming you’re bullish on the stock, high IV stocks are the best to target as you can collect more premium. This point is only correct if you anticipate a large downward move in the stock that would lose more than the premium received.

You should sell puts instead of CCs if you’re bullish on the stock. – There’s some nuance to this, but this point is mostly incorrect. Due to something called put-call parity, selling a put is conceptually similar to selling a covered call. Both will benefit from the same price movements.

Downsides:

There are a few downsides to CCs which you should consider before trading.

Funds required – Selling covered calls requires owning 100 shares of the stock. This is capital intensive. Consider buying 100 shares of GME which would cost $20,800. Buying a GME July 2 expiry call with 0.71 delta (meaning you get price appreciation that replicates owning 71 shares) only costs about $2,443.

Stock tanks and never recovers – If the stock tanks and never recovers, you won’t be able to recoup your losses; however, even if this happens, your outcome is better than the other strategies from before since you got to keep the premium.

The upside is limited – Your upside is capped at the strike price. If there’s a strong movement upwards, the other strategies are better; however, there may be situations where you call “roll” your option up in strike and out in expiry. This may allow you to keep stock.

Conclusion: Selling covered calls are an underrated trading strategy that is often misunderstood. It is profitable in a wide range of trading environments. Sure it may not be as “sexy” as buying FDs and it won’t get you rich overnight, but it can possibly provide strong and consistent returns over time.