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Covered Call: Profile Version / Simplified Version / Comprehensive Version
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 or Covered Call 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.
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?
A Covered Call consists simply of writing 1 contract of out of the money call options for every 100 shares of the underlying stock owned.
Buy 100 Shares + Sell 1 OTM CallIt could actually be executed in 3 ways; Simultaneous Order, Stock Protection or Short Covering.
Simultaneous order means that you buy the shares and write the OTM calls simultaneously.
Stock protection means writing out of the money call options on stocks that you already own and you wish to hedge it against a slight correction.
Short Covering means covering your short out of the money call options positions by buying the underlying stock, transforming the naked call write into a Covered Call.
You can find free videos on how these orders are made at the end of the page.
Which Strike Price To Write the Call Options On?
This is a common question asked by covered call beginners when confronted with the huge range of choice of options available in an options chain.
The further out of the money the call options are written, the more room there is for the stock to go upwards but the lower the premium received from the call options themselves. The effect is that the maximum profit potential rises (Assigned Return) but the profit received if the stock remains stagnant (the Static Return) as well as the protection received when the stock goes down becomes lesser.
The nearer the money the call options are written, the lesser room there is for the stock to go upwards but the higher the premium received from the call options themselves. The effect is that the maximum profit potential decreases but the profit received if the stock remains stagnant as well as the protection received when the stock goes down becomes higher.
Yes, there is no free lunch in options trading and options trading is all about trade-offs between profitability and risk. As such, your outlook on the performance of the stock is pivotal in deciding which strike price works best. If you expect the stock to go up significantly, you would write further out of the money call options while if you expect the stock go still go up only very slightly or not at all, you might decide to write just slightly out of the money call options or even at the money call options. A popular method used in options trading is to write the call options on the price you expect the stock to peak at.
Lets compare the effects of writing slightly out of the money call options and further out of the money call options.
In fact, you could even write Covered Calls using deep in the money options, known as the Deep In The Money Covered Call.
Which Expiration Date To Write the Call Options On?
Unless you have a strong reason to do otherwise, the practise in options trading for covered call writing is to write the nearest month options so as they expire fastest, putting time decay in your favor.
Trading Level Required For Covered Call
A Level 1 options trading account that allows the execution of Covered Call and Protective Put is needed. Read more about Options Account Trading Levels.
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.
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.
When your stock rises 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.
Profit Calculation of Covered Call:
As mentioned above, there are 3 different ways to look at a Covered Call's profit and they are known as; Static Return, Assigned Return and Expired Return.
Static return is the profit that a covered call generates if the stock remains totally stagnant. It is really a simple function of the amount of premium received versus the price of the stock itself. Assigned return is the maximum profit that a covered call is capable of generating which happens when the stock rises to or beyond the strike price of the short call options, triggering an assignment. Expired return is simply calculating the amount of profit if the stock rises but fails to exceed the strike price of the short call options. In options trading, covered call traders typically compare the Static and Assigned return prior to execution in order to decide if a covered call is worth trading for a certain stock and also to help them decide which strike price to write the call options on.
1. Static Return
Static Return = Premium of Call Options Written / Price of Stock
2. Assigned Return
Assigned Return = ((strike price of short call options - Price of stock) + initial price of short call options) / Price of stock
3. Expired Return
Expired Return = ((Stock price at expiration - Initial stock price) + initial price of short call options) / Initial price of stock
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
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
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
Covered Call Videos