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Covered Call - Definition
An options trading strategy which seeks to make a monthly income by selling call options against existing stock holdings.
Covered Call - Introduction
The Covered Call, also known as a Covered Buy Write, is the classic of classics in options trading. This is the options trading strategy that most beginners learn about and is
also the options trading strategy most widely taught.
The Covered Call allows you to make a monthly "rental" return on your current stock
portfolio, making a monthly income even when those stocks stay stagnant. The Covered Call can also be used to protect against
a short term drop in stock price. All these characteristics made the Covered Call an extremely useful
option trading strategy for all traders who holds long term stock positions.
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When To Use Covered Call?
One should use a covered call when one wishes to hold on to one's stagnant stock while making a monthly income from it. One can also use a covered
call to protect one's equity when the stock goes into a slight correction.
How To Use Covered Call?
Establishing a covered call is extremely simple. All you have to do is to write
(sell to open) 1 contract of nearest out of the money call option
for every 100 shares you own.
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Example : Assuming you own 700 shares of QQQQ at $44. Sell To Open 7 contracts of QQQQ Jan45Call.
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You could also choose to execute the Covered Call with At The Money call options instead. Doing so earns you a higher premium should the stock remain stagnant.
The drawback of
doing so is that you will not benefit from any gain in the stock should the stock price rise.
There is another variant of the Covered Call using deep in the money options, known as the
Deep In The Money Covered Call.
Profit Potential of Covered Call :
The Covered Call's maximum profit occurs when the stock closes exactly at the strike price of the short call options at expiration of the short call options.
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From the above example : Assuming your 700 QQQQ close at $45 upon expiration of the 7 contracts of QQQQ Jan45Call. You will make the $1 gain in QQQQ plus the
value of the 7 Jan45Call that you wrote.
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Such an ideal situation is, of course, rare. In most cases, the short call options will either be in the money or out of the money at expiration.
When your stock is stagnant or slightly higher upon expiration of the short call options, you will profit on the whole value of the call options that you wrote, with whatever profit from the stock if it is up slightly.
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From the above example : Assuming your 700 QQQQ close at $44.50 upon expiration of the 7 contracts of QQQQ Jan45Call. You will make the $0.50 gain in QQQQ plus the
value of the 7 Jan45Call that you wrote.
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When your stock has gained in price beyond the strike price of the short call options upon expiration, your stocks will be called off (assigned) and you will profit from the value of the call options that you wrote and the
value of the stock appreciation up till the strike price of the short call options. That is to say, you will not benefit from any rise in your stock beyond the strike price of the short call options due to the short call options going in the money.
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From the above example : Assuming your 700 QQQQ close at $46 upon expiration of the 7 contracts of QQQQ Jan45Call. You will gain the value of the
7 contracts of QQQQ Jan45Call that your wrote. Your 700 shares of QQQQ will be called off (bought by the person whom you sold the call option to)
at $45 (the strike price of the QQQQ Jan45Calls that you sold.) You will therefore make $1 from your stock, not $2.
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From the below profit calculations of the covered call, you will learn that you will make more profits if your stocks are assigned rather than when your stocks are not assigned. This is of course
a disadvantage if you would like to keep the stock for the long term.
Profit Calculation of Covered Call:
1. If stocks are not assigned (called off) at expiration:
Profit = (value gained in stock + initial price of short call options) / initial value of underlying stock
Assuming you bought 700 QQQQ close at $44 and sold 7 contracts of QQQQ Jan45Call for $1.00.
Assuming at expiration, QQQQ closes at $44.50.
Profit = ($0.50 + $1.00) / $44 = 3.41%
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2. If stocks are assigned (called off) at expiration:
Profit = ((strike price of short call options - initial value of underlying stock) + initial price of short call options) / initial value of underlying stock
Assuming you bought 700 QQQQ close at $44 and sold 7 contracts of QQQQ Jan45Call for $1.00.
Assuming at expiration, QQQQ closes at $46.00.
Profit = (($45 - $44) + $1.00) / $44 = 4.55%
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3. If stocks have dropped in value at expiration:
Profit = (initial price of short call options - (initial stock price - stock price at expiration)) / initial value of underlying stock
Assuming you bought 700 QQQQ close at $44 and sold 7 contracts of QQQQ Jan45Call for $1.00.
Assuming at expiration, QQQQ closes at $43.50.
Profit = ($1.00 - ($44 - $43.50)) / $44 = 1.14%
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Risk / Reward of Covered Call:
Upside Maximum Profit: Limited
Maximum Loss: Unlimited
Break Even Point of Covered Call:
There are 2 ways to look at breakeven point for a covered call.
1. As the Covered Call profits mainly from the decay of the short out of the money call options, the main way to look at breakeven is
the number of days it takes for the decay of the short call options covers its bid/ask spread.
Stagnant Breakeven point = Bid ask spread / theta
Assuming the ask price is $1.00 and bid price is $1.05 with a theta of -0.012.
Stagnant Breakeven Point = ($0.05 / 0.012) = approximately 4 days.
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2. The lower breakeven point to find out how much the underlying stock can fall before you start making real losses to your account value.
Lower Breakeven point = Initial Value of Short Call Options - Initial Value of underlying stock
Assuming you bought 700 QQQQ close at $44 and sold 7 contracts of QQQQ Jan45Call for $1.00.
Lower Breakeven Point = ($1.00 - $44) = $43.00
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Advantages Of Covered Call:
Able to profit even if your stock stays stagnant.
Able to offset losses if your stock drops in value.
No margin required for writing call options.
Disadvantages Of Covered Call:
You must continue to hold your stocks if you want to keep the short call options.
You can lose your stocks if it rises beyond the strike price of the short call options through
assignment at expiration.
Alternate Actions for Covered Calls Before Expiration :
1. If you wish to keep your stocks when it has gained in price beyond the strike price of the short call options, you could buy back
the short call options before it expires and allow the stock to continue its profit run.
2. In addition to keeping your stocks using the action above, you could also use the excess money after the buy back to buy put options
at the money in order to protect the current profits of the stock. This is known as a Protective Put.
3. If your stocks are up way before expiration and is losing upside momentum, you could buy an equal amount of put options at the money
as you have short call options. This forms an options trading strategy called the Collar.
Questions Concerning Covered Calls
"Is Margin Needed for Covered Call?" asked by Tony
"How Do I Keep My Covered Call Stock From Assignment?" asked by Geoffrey
"Is Covered Call The Safest?" asked by Apurva
"What Happens To My Covered Call On Citigroup?" asked by Farzin
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