Posted on Leave a comment

Trading Covered Calls – A “Call” To Arms

  •   
  •   
  •   
  •   
  •   
  •   
  •  

Introduction

 

 

We’ve all heard the saying “the trend is your friend”. This is true when the trends is moving in your direction. Over the course of holding stock, investors expect it to rise over the long term.

But keep in mind that stocks rally, pull back, rally, and pull back over and over again. Obviously, if you own a stock, you won’t profit when it moves down or sideways in the short term.

So what can you do?

The answer might be to sell covered calls. By selling a covered call, you could generate a small amount of income and help reduce volatility.

In this lesson, we’ll discuss the basics of trading covered calls. You’ll learn what a covered call is, how to analyze its risk profile, and gain a better idea of whether this strategy is right for your portfolio.

 

But before we begin, we would like you to read and agree to the Terms & Conditions of this post before you proceed any further.

Disclaimer: Invest In Wall Street is in no way financially or legally responsible for any investing decisions made by any of our readers and are, in turn, acting on their own free will. The information in this article is purely educational and should not be abused or misconstrued in any way, shape, or form.

 

Covered Calls

 

Let’s start by defining what a covered call is. A covered call is when an investor sells a call option contract against an underlying stock position.

When you sell or short a call option, you sell someone else the right to buy your stock at a set price. As part of this deal, you’re obligated to sell your stock if the option is exercised.

 

 

Let’s look at the risk profile of a short call option to get an idea of the gains and losses involved in this strategy.

The risk profile for a short call option shows the maximum profit that can be made if the underlying stock trades below the stock price of the call you sold. After selling the call, time decay works in your favor – with each passing day, a step closer to expiration.

Of course, when you sold the call, you also limited the upside potential of the stock for the amount of time you hold the short call.

If the stock price rises sharply, you may find that you are assigned, which means you’re obligated to deliver your shares.

When combining the risk profile of the short call with the risk profile for owning a stock, it shows the strategies bullish nature, but also displays the profit limit.

How To Trade A Covered Call

 

 

 

So how do you set up your covered call trade?

It depends on whether your desire is to keep the stock in your portfolio or let it go. The strike price you choose will determine the likelihood of hanging on to the stock.

If you want to keep the stock and generate a little income, a common approach is to sell an “out of the money” option. Of course, whenever you sell a covered call, there is the real risk you may not get to keep the stock.

If you’re not concerned about keeping the stock and want more income, a typical scenario is to sell an “at the money” option.

In this lesson, we’ll be focusing on “out of the money” options that generate a little income while hopefully keeping the stock.

Selling “out of the money” calls may provide room for your stock price to rise before hitting that profit limit.

Because of this gap between the call strike price and the stock’s current price, you have probability on your side – and odds are that the call option will expire worthless.

 

 

Here’s a quick example of how you might create out of the money covered call rules in an investing plan.

First, use an uptrending optionable stock already in your portfolio or enter an uptrending optionable stock.

Next, look at option contracts with 20 to 50 days remaining until expiration. Then, choose an option to sell with a delta of 0.30 to 0.40.

After selling the call, there are a few guidelines to follow when managing your trade:

If there are between four and ten days remaining, consider buying back the call regardless of where the stock is.

If the stock breaks a significant support level, you may want to exit the trade by buying back the call and selling the stock.

Income from covered calls – even if its a small amount – could make pullbacks profitable, or at least less painful.

 

 

Quick Recap

In Review….

The Basics Of Covered Calls

 

  • Let’s start by defining what a covered call is. A covered call is when an investor sells a call option contract against an underlying stock position
  • When you sell or short a call option, you sell someone else the right to buy your stock at a set price. As part of this deal, you’re obligated to sell your stock if the option is exercised
  • The risk profile for a short call option shows the maximum profit that can be made if the underlying stock trades below the stock price of the call you sold. After selling the call, time decay works in your favor – with each passing day, a step closer to expiration
  • Of course, when you sell the call, you also limit the upside potential of the stock for the amount of time you hold the short call
  • If the stock price rises sharply, you may find that you are assigned, which means you’re obligated to deliver your shares
  • When combining the risk profile of the short call with the risk profile for owning a stock, it shows the strategies bullish nature, but also displays the profit limit

 

Trading Covered Calls

 

  • It depends on whether your desire is to keep the stock in your portfolio or let it go. The strike price you choose will determine the likelihood of hanging on to the stock
  • If you want to keep the stock and generate a little income, a common approach is to sell an “out of the money” option. Of course, whenever you sell a covered call, there is the real risk you may not get to keep the stock
  • If you’re not concerned about keeping the stock and want more income, a typical scenario is to sell an “at the money” option
  • Selling “out of the money” calls may provide room for your stock price to rise before hitting that profit limit
  • Because of this gap between the call strike price and the stock’s current price, you have probability on your side – and odds are that the call option will expire worthless

 

 

 

And these are the very basics of covered calls – and as you can already tell, they are an advanced options strategy that can be used by investors and traders alike. The basis of this strategy is that you have a particular stock that you already own – and where you go on to write off (sell) a call option with the intention of making some extra cash. So in the event that a stock in your portfolio is downtrending, you can make a quick profit through a covered call.

Although, it should be noted that the max profit is “capped” – so in other words, the price that you decide to sell the stock option at is the max profit that you can get.

Its primarily used a defensive strategy with the extra incentive to earn a little revenue on the side. However, there are risks to trading covered calls – as they are with all other investments.

I hope you have enjoyed this post and found the information to be quite useful. If you have any questions or concerns, please feel free to leave them down in the comment thread below and make sure to like and share this post.

  •  
  •  
  •  
  •  
  •  
  •  
  •  
Leave a Reply

Your email address will not be published. Required fields are marked *

This site uses Akismet to reduce spam. Learn how your comment data is processed.