Covered Calls

Doc and ToddIn a covered call trade, you are buying the underlying stock shares and selling call options against it. This strategy is best implemented in a bullish to neutral market where a slow rise in the market price of the underlying stock is anticipated. This technique allows traders to handle moderate price declines because the call premium reduces the position’s breakeven. Since you are counting on the time decay of the short option to render the short call worthless, you do not want to sell a call more than 45 days out. However, since the profit on a covered call is limited to the premium received, the premium needs to be high enough to balance out the trade’s risk. Table 5-1 (next page) illustrates the advantages a covered call offers in comparison simply to purchasing stock.

Covered Call Strategy vs. Long Stock Strategy

Market Scenario

Covered Call

Long Stock

Stock price increases: Call is exercised and the underlying stock shares are sold at the call’s strike price

Profits are limited to the premium received on the short call plus the profit made from the difference between the stock’s price at initiation and the call strike price

Profits may be garnered if the stock is sold at the higher price.

Stock price remains stable: Call expires worthless and the trader still owns the stock shares

Profits are limited to the premium received on the short call.

No profit is made.

Stock price decreases: Call expires worthless and the trader still owns the stock shares.

The breakeven on the stock is lowered by the premium received on the short call.

Losses accumulate as the stock price declines below the initial price paid for the stock.

Unlike vertical spreads, there are a limited number of choices that depend on the available option premiums. As previously mentioned, the key to a successful covered call lies in finding a stable market with slightly otm options with less than 45 days till expiration with enough premium to make the trade worthwhile. Using the values in Table 1-2, it’s easy to see that the January 80 option is the only viable choice for a covered call strategy. Let’s create a covered call by purchasing 100 shares of Wal-Mart Stores stock and selling 1 January wmt 80 call at 4 ¼. The risk graph for this trade is shown in Figure 1-b. The profit line on this trade slopes up from left to right. Conveying the trader’s desire for the market price of the stock to rise slightly. It also shows the trade’s limited protection. If Wal-Mart Stores declines beyond the breakeven, there is unlimited risk on the stock all the way to zero.

Price of wmt = 71 ½

Call Strike Price

December

January

65

11 ¾

12 ¾

70

7

8 7/8

75

3 ¼

6

80

1 15/16

4 ¼

85

¾

2 ½

Let’s create an example using Wal-Mart Stores, Inc. (wmt) by going long 100 shares of wmt @ 71 ½ and short 1 January wmt 80 Call @ 4 ¼. The maximum profit for this trade is the premium received for the short call option plus the profit to be gained on the long stock. The maximum reward on the option side of this position is $425 (4 ¼ x 100 = $425). The maximum reward on the stock side of this position is $850 [(80 – 71 ½) x 100 = $850]. The total profit on this particular covered call strategy is $1,275 (425 + 850 = $1,275). The maximum risk is limited to the downside as Wal-Mart drops in price beyond the breakeven all the way to zero. The option side of this trade does not require a margin deposit to place because the short call option is already covered by the long stock.

The breakeven on a covered call is calculated by subtracting the call option premium from the price of the underlying stock at initiation. In this example, the breakeven is 67 ¼ (71 ½ – 4 ¼ = 67 ¼). WaWal-Mart must drop below 67 ¼ for the trade to begin to take a loss (not including commission costs). The maximum profit of $1,275 will be received if the stock rises to or above 80 and the call is exercised.

On December 24, Wal-Mart climbs above $80 per share. If the short 80 call is exercised, 100 shares of Wal-Mart will be sold to permit delivery to the assigned option holder. The $425 credit from the option and the additional profit from the sale of the Wal-Mart shares bring the total profit on the trade to $1,275.

Long 100 shares wmt @ 71 ½, Short 1 January wmt 80 Call @ 4 ¼
Debit at Initiation Stock Price at Exit Days in Trade Profit / Loss
$7,150 – $425 = $6,725 80 22 $1,275

Covered calls are the most popular option strategy used in today’s markets. If a trader wants to gain additional income on the same stock, he or she can sell a slightly otm call every month. The risk lies in the strategy’s limited ability to protect the underlying stock from major moves down and the potential loss of future profits on the stock above the strike price. To increase protection, covered calls can be combined with buying long-term puts (over 6 months). Calls can then be sold each month with the added protection of the long puts.

Covered Call Strategy Review
Strategy = Buy the underlying security and sell an otm call option
Market Opportunity = Look for a bullish to neutral market where a slow rise in the price of the underlying is anticipated with little risk of decline
Maximum Risk = Virtually unlimited to the downside below the breakeven all the way to zero
Maximum Profit = Limited to the credit received from the short call option + (short call strike price – price of long underlying asset) times value per point
Breakeven = Price of the underlying asset at initiation – short call premium received
Margin = Required. The amount is subject to your broker’s discretion.

About the Author Todd Mitchell

Todd Mitchell is the CEO & Founder of Trading Concepts, Inc. He's been trading since 1994 and has mentored over 12,000 traders from Wall Street to Main Street. He's an expert at developing strategies for creating more consistent daily, weekly and monthly income.

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