Your Inside Source for Options Information

September 25, 2018

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The risks and rewards of using covered calls

Description

An investor who buys or owns stock and writes call options in the equivalent amount can earn premium income without taking on additional risk. The premium received adds to the investor's bottom line regardless of outcome. It offers a small downside 'cushion' in the event the stock slides downward and can boost returns on the upside.

Predictably, this benefit comes at a cost. For as long as the short call position is open, the investor forfeits much of the stock's profit potential. If the stock price rallies above the call's strike price, the stock is increasingly likely to be called away. Since the possibility of assignment is central to this strategy, it makes more sense for investors who view assignment as a positive outcome.

Because covered call writers can select their own exit price (i.e., strike plus premium received), assignment can be seen as success; after all, the target price was realized. This strategy becomes a convenient tool in equity allocation management. 

The investor doesn't have to sell an at-the-money call. Choosing between strike prices simply involves a tradeoff between priorities.

EXAMPLE

• Long 100 shares XYZ stock
• Short 1 XYZ 60 call

MAXIMUM GAIN

• Strike price - stock purchase price + premium received

MAXIMUM LOSS

• Stock purchase price - premium received (substantial)

The covered call writer could select a higher, out-of-the-money strike price and preserve more of the stock's upside potential for the duration of the strategy. However, the further out-of-the-money call would generate less premium income, which means there would be a smaller downside cushion in case of a stock decline. But whatever the choice, the strike price (plus the premium) should represent an acceptable liquidation price.

A stock owner who would regret losing the stock during a nice rally should think carefully before writing a covered call. The only sure way to avoid assignment is to close out the position. It requires vigilance, quick action, and might cost extra to buy the call back especially if the stock is climbing fast.

Outlook

The covered call writer is looking for a steady or slightly rising stock price for at least the term of the option. This strategy not appropriate for a very bearish or a very bullish investor.

Summary

This strategy consists of writing a call that is covered by an equivalent long stock position. It provides a small hedge on the stock and allows an investor to earn premium income, in return for temporarily forfeiting much of the stock's upside potential.

Motivation

The primary motive is to earn premium income, which has the effect of boosting overall returns on the stock and providing a measure of downside protection.

The best candidates for covered calls are the stock owners who are perfectly willing to sell the shares if the stock rises and the calls are assigned.

Stock owners that would be reluctant to part with the shares, especially mid-rally, are not usually candidates for this strategy. Covered calls require close monitoring and a readiness to take quick action if assignment is to be avoided during a sharp rally; even then, there are no guarantees.

Variations

Covered calls are being written against stock that is already in the portfolio. In contrast, 'Buy/Write' refers to establishing both the long stock and short call positions simultaneously. The analysis is the same, except that the investor must adjust the results for any prior unrealized stock profits or losses.

Max Loss

The maximum loss is limited but substantial. The worst that can happen is for the stock to become worthless. In that case, the investor will have lost the entire value of the stock. However, that loss will be reduced somewhat by the premium income from selling the call option.

It is also worth noting that the risk of losing the stock's entire value is inherent in any form of stock ownership. In fact, the premium received leaves the covered call writer slightly better off than other stock owners.

Max Gain

The maximum gains on the strategy are limited.

The total net gains depend in part on the call's intrinsic value when sold and on prior unrealized stock gains or losses.

The maximum gains at expiration are limited by the strike price. If the stock is at the strike price, the covered call strategy itself reaches its peak profitability, and would not do better no matter how much higher the stock price might be. The strategy's net profit would be the premium received, plus any stock gains (or minus stock losses) as measured against the strike price.

That maximum is very desirable to investors who were happy to liquidate at the strike price, whereas it could seem suboptimal to investors who were assigned but would rather still be holding the stock and participating in future gains. The prime motive determines whether the investor would consider post-assignment stock gains as irrelevant or as a lost economic opportunity.
(Source: OIC)

 

Upcoming Economic Reports

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Options Insider Radio Network 

Episodes from the network highlighting covered calls

Options Bootcamp 63: The Proper Way to Trade Covered Calls

Posted July 29th, 2016

Options 101: Our topic today was inspired by a listener question.

• Question from Mark Davis: Hello, I am a new listener to options bootcamp and am currently on Ep. 4. There was a mention of using covered calls to generate a "dividend." I am having trouble tracking down more information on this. Being still new to all of this I am hoping to get a clearer picture of how it works. How far out on expiration should I look and how do I figure the strike price? Thanks!

Mail Call: Even more listener questions and comments

• Question from Robert Kornacki: I would like to use strategy regarding naked puts. If the naked put is far out of money what strategy could I use to protect myself? Could I use some type of order in case it was getting close to naked put strike price? Thanks
• Question from Dmitry Shesterin: What happens to LEAPs for tickers that get delisted before expiration?
• Question from Fred: I read Natenberg options volatility and pricing twice now and I have also set up paper trading accounts. But I am stuck going forward in my options progression. I do not want to trade using the Greeks formula. But I want to spec on crude futures intraday using options. What should I do? Should I make more SIM trades until I figure it out? Or am I just too ignorant to trade options?
• Question from Jack Rieger: Do you have any specific strategies near or on expiration to profit from theta decay?
• Question from Bobby: How long did it take you to become comfortable trading credit spreads? Also what is my max loss when trading a credit spread?
• Question from Tor: Hello. I am (restarting) my options trading on a shoestring; any thoughts on mini-options? Thanks.
• Question from Fred (#2): Is it my imagination or do options traders trade more markets than futures traders do? Is that a good practice? Is it good to look for multiple markets when trading options? Should I expand my horizons?

Options Bootcamp 55: Going Naked in IRAs

Posted March 26th, 2015

Options Bootcamp 55: Going Naked in IRAs

Basic Training: Using Options in an IRA Account. Can you trade options in a retirement account? What are the limitations? What strategies can you utilize? What are the benefits of writing covered straddle vs calls? What is a stock replacement strategy? When should someone consider this strategy? Using options as an investment tool. What are any other investment strategy?

Mail Call: Listener questions and comments

• Question from Hector - Can I still trade mini options or are they no longer available?
• Question from Neil Cerone - What are the most common mistakes you see from "stock guys" who try to become "options guys?"
• Question from Steve: First off, I love ALL the shows. They fill my daily commute with wit AND wisdom. Thanks! Also, better late than never, it was great meeting you all at Benny’s Chophouse back in Sept. I am one of the Lobster and Meatballs trainees (thanks to your shows). I had the pleasure of sitting right next to you and across from Uncle Mike as we devoured steaks on The Greasy Meatballs tab. That would be Extra pleasure as Sebastian was paying for them! However, I gotta tell you that you blew it big time the other day when trying to describe why a Leap Call Diagonal is called the "Fig Leaf". Brian named it the "Fig Leaf" because you are "kinda covered but not exactly" due to the curves in the profit graph. I think that makes perfect sense and is pretty funny to boot. Finally, on a side note I would love to hear Uncle Mike explain what is and what is not considered holding in the NFL. It boggles my mind to see play after play of inconsistent enforcement. I understand if that’s out of scope, but what the hell I thought I would ask anyways. It is not too often you meet a Pro Lineman. Best regards - Steve aka "Hawkeye".

Options Bootcamp 38: Triple Income Trading

Basic Training: The Wheel Trade

A great trade for novice options traders. Our friends at RCM call this the "triple income trade" or "the wheel of fun."

What is it? Write a put to get long equity, then immediately write a call to sell equity. When should you use it? When should you not use it?

This is a great way to add some extra bang to your covered call trades.

Mail Call: Fabulous questions, insightful answers.

• Question from Bit Tim: You recommend closing out your shorts when they go your way. Do you advise factoring the closing price of the trade in to your calculations when writing options? For example - write a put for $.30, but know at the onset that you will only collect $.25, because you will close it out for $.05. If more people did that at the outset, they might be less reluctant to close out their winner for a profit.
• Question from Jack - I know you guys are not tax advisors, and so nothing you say can be taken as certain in any answer to this question. I am a small time trader, and at the moment cannot afford a CPA with trading expertise in options to do my taxes. So I am wondering if you can talk about the potential tax consequences of front spreads, especially when used as covered call replacements. I have had good success with this strategy, and I would like to move it into my margin account this year, instead of just using it in the IRA to avoid the tax headache.
• Question from Alejandro Garcia, NYC - Given Wang's experience in the Chinese market, I would be interested to hear John's take on the impending launch of listed options in China in April. Does he think it will be a success? What will the popular strategies will be with Chinese options traders?

OICs Wide World of Options 29: Generating Income with Options

Posted May 17th, 2016

Joe Burgoyne talks all about income generation this month with interviews with Dan Sheridan from Sheridan Options Mentoring, and The Options Lady, Laurie Itkin. Topics include covered calls, selling puts, spreads and condors.

OICs Wide World of Options 19: Covered Calls and Climbing the Wall of Worry

Posted June 1st, 2015

CBOEs Peter Lusk joins Joe Burgoyne to discuss motivations behind using the covered call strategy. Also, do you know what it means to "climb the wall of worry"? Joe has your answer on today's Looking Back segment.

 

WWoO Show 15: Covered Call Combinations and Volatility Charts

Posted October 31st, 2014

On Strategy Spotlight, Joe Burgoyne discusses Covered Call Combinations with Randy Frederick of Schwab. Then Shelly Brown of MIAX stops by to discuss what's new with the exchange. Want to learn more about volatility charts? Joe has the 4-1-1 on Tools, Resources and Good Reads.

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