Covered calls are one of the most straightforward and profitable trading strategies available to traders. It is a swing trading strategy that can be used even when the market is in a downturn. In this article, we will discuss what covered calls are and how to trade your first covered call. With a basic understanding of stock options, you can start trading covered calls and profiting from them today!
Before discussing a covered call, let’s discuss options and review basic options terminology.
Options are a type of security that gives the holder the right to buy or sell an equity at a specified price on or before a given date (known as the expiration date). The two main types of options are called ‘calls’ and ‘puts .’Calls provide the trader the right to buy an underlying asset, while put options give the holder the right to sell it.
The underlying asset can include anything from shares of stocks, ETFs, or futures commodities, like silver or oil. The strike price is the price the trader is negotiating to buy or sell the asset. The expiration date is the contracted date on which the option must be exercised or enforced.
Options act similar to an insurance policy like a homeowner’s policy, where the insurance company writes or sells you (as the buyer) a policy to protect you against a catastrophic event. The insurance company is a seller, and they collect a premium from you since you are the buyer of the policy.
With options, it is essential to understand whether or not you are acting as a buyer or seller (“writer”) of an option.
Buying Options (Buy to Open)
When purchasing a call option, you are accepting the right to buy an underlying security at a specified price (i.e., the strike price) in the future. If you get a put option, you obtain the right to sell an underlying security for the specified price later on in the future. The set price is known as the strike price.
The main difference between a call and a put is who is obligated to perform the trade. When you buy a call, you must purchase the security if the holder of the option exercises their right to do so. Conversely, when you buy a put, you must sell the asset if the holder of the option exercises their right.
Typically, a “buyer” purchases a call option if they expect the price of a stock to rise, and they buy a put if they expect the stock price to drop.
Selling Options (Sell to Open)
However, when selling a call option, you must sell the security at the strike price if the option is exercised or if the option expires in the money (i.e., is valid when it expires). Either way, you get to keep the premium as profit.
When you sell a put option, you collect a premium from the buyer. In addition, you agree to buy the security at the strike price if the buyer decides to execute their option.
Usually, a “seller” writes a call option expecting the stock price to drop, and the “seller” writes a put option expecting the stock price to climb.
Now that we’ve reviewed covered calls and puts, let’s discuss now review covered calls. A covered call is where a trader holds shares in an asset and writes or sells call options on that asset. The key word here is “covered.” This means you own the underlying security on which you are writing the calls. If you have heard of the term “naked” calls, this primarily refers to a trader who does not own the security but sells calls on them. Going naked is a risky strategy and should probably be avoided. To stay covered, typically, you will need 100 shares of the stock for every covered call option contract that you sell.
Covered calls are a way to generate income from your long position while also providing some downside protection. If the price of the asset drops, the calls will offset some of those losses incurred and still allow you to own the stock. But, if the underlying asset’s price climbs substantially, you will miss out on some of the upside potential because you have sold away your rights to purchase the security at a lower price.
Through selling a covered call, you have the right to purchase 100 shares of stock at a specified price (for every contract sold). The buyer of the covered call is betting that the stock will increase in value, while the seller is betting that it will stay relatively flat or decline slightly.
If the stock price rises in value, the buyer has the right to purchase the shares at the negotiated strike price, resulting in a profit for the seller. If the stock price decreases or stays relatively flat, the covered call expires worthless, and the seller keeps the entire premium.
To trade a covered call, you must first find a stock that you believe will trade sideways or decrease slightly throughout the options contract. Once you have found a stock, you will need to determine the strike price and expiration date of the covered call.
Once you have determined the strike price and expiration date, you will need to sell the covered call to a buyer. You can trade covered calls through a broker or most online trading platforms. See the example below for thinkorswim. Once you have sold the covered call, you will need to monitor the stock price closely. If the stock price increases, you may be assigned and be obligated to sell your shares at the strike price. If the stock price declines or stays relatively flat, the covered call will expire worthless, and you will keep the entire premium. Just note that in either of these cases, the seller can keep the premium earned.
Covered Call Risks
Covered calls are a popular options strategy because they offer limited downside risk and unlimited upside potential. However, this strategy still has risks to take into account. The most significant risk is that the underlying security price will increase so much that it will offset the premiums you have received from selling the calls. Another risk is that the underlying security will not be called away, and you will miss out on potential profits.
If you are considering using a covered call strategy, there are a few things to keep in mind:
- Always know the risks involved with selling options.
- Ensure that the strike price selected is high enough, so there is a little chance that the stock is called away.
- Be careful to review the expiration date of the options.
Covered Call Tips
1. Decide if you want to keep your shares: If you are more interested in keeping your stock shares and not running the risk of selling them at the strike price, then when writing covered calls, consider:
a. Choosing strike prices far away from the current price. You may end up collecting less premium in these cases, but you run the risk of not letting go of your shares.
b. Choose an option with a delta of .30 or less. For more information on option delta, check this article on Options Greeks.
2. Stay away from earning announcements: Close any positions before earnings announcements as these could have volatile swings to the upside or downside (further increasing your risk).
3. Choose a close expiration date
Trade Your First Covered Call
We recommend testing this first in your simulations account before trading this in your live account.
1. Chose a stock that you own at 100 shares and want to write a covered call.
2. Pull up the Options chain on thinkorswim for the stock.
3. Review the current price. Decide on a strike price far above the current price. Determine the expiration date that you want to select.
4. Double click the ‘Bid’ price on the left side to open a sell position on the CALLS side.
5. Select the quantity and the limit price. The limit price will be the amount of money collected from the buyer of the option. If 5.99 is the limit price, you would collect 100 x 5.99 = $599.
6. Review the trade and select ‘Confirm and Send’.
7. The confirmation screen appears. Review the details for the covered call and confirm your risk on the trade. Select ‘Send’.
Covered calls are a great vehicle to generate income from your long position in an asset. You can stay profitable if you understand the risks involved and consider both the options’ strike price and expiration date.
Although covered calls can be an easy trading strategy to earn consistent money. It can take time to realize the profits from your trades, which is why we recommend our day trading strategy to help you make money faster through day trading.
Maurice Kenny has helped over 600 people become financially free through one-on-one coaching, mentorship, and options trading strategy. Many of these new traders are now full-time traders, and they all started by watching his 1-hr webinar.
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