How can you turn your otherwise lifeless stock positions into income generating machines?
You are probably holding a bunch of stock that hasn’t done anything for you. If the company isn’t paying a dividend, you are only racking up unrealized gains, or worse, losses. Unfortunately, holding stock doesn’t do anything for your portfolio until you actually sell it.
Covered calls give us a way to generate a consistent income from the stock that we are already holding. By learning how to fine tune your covered call strategy, you can generate income, minimizes losses, lower your cost-basis, and better utilize your portfolio.
To achieve these results, you will need to understand the basics of covered calls, how to develop a plan of action, what risks this strategy poses, and how to calculate your total return.
Basics Of Covered Calls
A covered call is an option trading strategy that combines long shares of stock with a short call. For every 100 shares you own, you want to sell 1 call contract.
Covered calls will typically be your introductory strategy into options. Covered calls are very easy to implement, and the risk is both, defined and minimized.
Besides being a good first step into options, covered calls offer a way to generate income on your long stock positions. Covered calls can be combined with dividend paying stocks to increase the amount of income from the position. You do not have to use your entire position.
If you have 1000 shares of The Option Prophet (sym: TOP] that are paying a nice dividend, you may not want to write calls on the entire position.
Instead, you can write calls on half, 500 shares, or even the minimal amount, 100 shares.
When you don’t have any positions in your portfolio, or any positions that you want to write covered calls on, you can open a new position and sell a call on it in one order. When you do this, it is known as a “buy-write” order. Buy-write orders give you the ease of creating one order and having it filled at your specified price.
When selecting a stock to write a call on, you want to find one that is trading with average implied volatility. A volatility percentile rating between 30 and 70 is ideal. A stock with low implied volatility won’t give you good premiums for your calls; your return would be too low. A stock with high implied volatility runs the risk of the stock moving around too much. A stock that moves around too much is difficult to control and plan for. Finding a stock that has average implied volatility will give you good premiums and be more predictable in terms of movement.
How To Develop A Plan For Covered Calls
One of the biggest downfalls on any trading strategy is failing to plan. Not having a trading plan in place when trading covered calls leaves you vulnerable to emotions and quick decisions.
When you trade without a plan, you will enter a position and have it move against you, leaving you frozen like a deer in the headlights. When trading without a plan, you let emotion take over your decision making. It is impossible to leave emotion out of trading, but letting it make the decisions for you is a great way to ruin your portfolio.
A covered call trade can follow one of three scenarios:
- The underlying stock rises above your strike price, your shares will get called away at expiration.
- For example, you own 100 shares of The Option Prophet (sym: TOP) at $45 and you sell 1 call contract at the 50 strike. This is a covered call. If TOP is trading at $51 at expiration your call option would be assigned and you would sell your 100 TOP shares at $50. You would make money on the increase in the underlying plus the credit for which you sold the call option. No further action needs to be taken on your part.
- If the underlying fails to move up to the strike price by expiration, your call would expire worthless, allowing you to collect the full credit of your option. You will keep your shares, and you can sell another covered call on the position. This is your best case scenario. You want to sell the call on your stock, but you want the stock to stay where it is. Your profit in the long run would increase if you can continue to sell calls against your position and never have them called away.
- The underlying stock moves lower. This won’t affect your option. In fact, you will still collect the full premium for your short option, as in the other scenarios. You do not have to wait for your option to expire worthless. If the underlying begins to move lower, you can buy back your call option at a lower price and collect a portion of the credit received. Now, you will need to decide if it is in your best interest to sell another covered call.
2 Risks Of Trading Covered Calls
All trading strategies come with some sort of risk. The advantage to covered calls is that they have minimal risk that won’t destroy your portfolio. With covered calls, the risks lie in the underlying and not with the options themselves.
First, covered calls limit your upside potential. It doesn’t matter if the underlying is 1% or 10% above your strike price, you will still have to sell your shares at the strike price. You run the risk of having the underlying shoot past your strike price, leaving you unable to capture the profit.
This situation goes hand-to-hand with traders that want to sell calls on their long stock but don’t actually want to part with their long stock.
The solution is the same for both. Before you sell calls on your long stock, you need to be okay with letting your long stock go at the strike price. Do not sell calls if you don’t want to see the stock called away, simple as that.
Otherwise, what happens is that the call will begin to increase in price (not what you want to happen), and you will be forced to buy it back at a loss. When trading covered calls, you shouldn’t take a loss on the option side of your trade.
Your second major risk with covered calls is having your underlying move down. A slight move lower won’t affect your overall position, but if the underlying begins to drop significantly it will increase the losses in your underlying position.
This is only a problem if you are not committed to holding the stock for the long term. Long term investors are fine holding a stock that drops in price because they believe in the long run that the price will increase.
However, if you are not a long term trader, then having the stock drop in price could hurt your overall position. Closing your stock at a predefined price is a good plan of action. First, however, you must buy to close your short call option. Leaving your call option open when you close your stock position will create a naked call. Naked calls can have considerable risk and should be avoided whenever possible. A lot of brokerages wouldn’t allow you to make this trade unless you are cleared for their highest option trading level.
Calculating Your Return
If you are going to run a covered call trading strategy, you need to know how to calculate your return. You have two types of returns to calculate, expired return and called return.
Your expired return will be your return if your option is not in-the-money and your stock does not get called away.
The formula for expired return is:
Call Premium / ((Stock Price – Call Premium) x 100 shares)
For example, if you sold a call at the 55 strike on TOP that is trading for $50 and collected a $3.00 premium, your return would be:
300 / ((50 – 3.00) x 100) =
300 / (47 x 100) =
300 / 4,700 =
Your called return is the return you will make if your option is in-the-money at expiration and you are forced to sell the shares.
The formula for called return is:
(Call Strike – Stock Price + Call Premium) x 100 shares / ((Stock Price – Call Premium) x 100 shares)
Let’s use the same example above but now we will factor in that TOP was trading at $60 at expiration, so you were assigned and the shares were called away.
(55 – 50 + 3.00) x 100 / ((50 – 3.00) x 100) =
(8 x 100) / (47 x 100) =
800 / 4,700 =
The return is higher when the stock gets called away because we factor in the profit from the sale of the underlying shares too.
In both of these formulas we used the price at which we purchased the stock, but that is not always the case. Cost basis is how much you pay for the underlying. Typically, this is the stock price multiplied by the number of shares plus your commissions.
When you trade covered calls you are lowering your cost basis. Let’s look at an example:
You purchased 100 shares of TOP for $50.00 and sold the 55 strike call for 2.50.
Your cost basis would be:
50 - 2.50 = $47.50/share
Let’s say that TOP never made it to $55 by expiration so your call expired worthless. You are still holding your shares so you decide to sell another call for 1.50.
This would continue to drop your cost basis, now down to:
47.50 – 1.50 = $46/share
Cost basis is important to understand. It gives you more options in term of your breakeven on the underlying and you have more options in terms of selling covered calls.
If you’ve decided you no longer want to hold TOP, but it is only trading at $47, you know you could sell the position and know you are profitable because it is above your cost basis.
On the other hand, you can continue selling calls above your cost basis and remain profitable. You want to make sure that when you are selling calls, if your stock was called away, that you wouldn’t end up with an overall loss.
Covered calls can be a good strategy to include in your portfolio to generate extra income. You can use stocks that are already in your portfolio or open new positions on which to trade covered calls.
Covered calls will lower your overall cost-basis on your position. This will increase the return when you do decide to sell your shares, or when they are called away. It will also lower your breakeven on the position or it could reduce your loss, if it comes to that.
Even though covered calls are a beginner option strategy, they should not be discounted.
What stocks do you like to trade covered calls on? Let us know in the comments...