Depending on your portfolio objectives, you will want to use certain kinds of options strategies. The Covered Call is a classic options strategy where a trader buys stock and then sells a call option on that same stock. The traditional approach to this strategy is to sell the call out of the money. In this series, we will examine some of the core and classically used options strategies. This entry is for the Covered Call.
When you’re new to options it is wise to start simple. There are all kinds of complex strategies that involve multiple legs and an intermediate or advanced understanding of options that you can learn after you’ve mastered the basics. But don’t be mistaken, just because the Covered Call is a simple strategy that doesn’t mean that advanced or experienced traders don’t use it. The more you trade – you may want to focus on the basics and put your time into perfecting them.
Covered Calls are used by both traders and investors alike. Traders tend to focus on shorter-term expirations and do much more rolling of the call and adjusting on the trade in general than investors. Investors tend to set it and forget it and come back occasionally to adjust their positions or check their stocks. We will examine both mind-sets and techniques.
Let’s start with the stock portion of the Covered Call strategy.
If you currently own stock, then you already have an asset that you can sell calls against to generate income and a profit. If you don’t own any stock, then you will need to scan or locate a company that you want to purchase that also fits your money management rules.
One example that is frequently used to help people understand the power of covered calls comes from the Real Estate market. It’s possible some of you have owned property that you have rented out for income. Imagine you decide to upgrade from your current home, and you find your dream home to move into. But, instead of selling the house you live in you decide to turn it into a rental to generate some consistent income. You have the potential to have a nice cash-flow machine. What’s the only problem? Tenants. If you can find the right people to move into your house that won’t trash it and will pay the rents every month – that’s great! If you happen to have some of the other kind of tenants that aren’t consistent with the rent and leave the house in shambles – well that can be a problem.
If you own a stock you own an asset just like when you own a house. But this asset doesn’t require tenants. The market is so large and liquid that you can simply open your brokerage account every month and collect your credit. Here is an example to help us understand the point. If you have 1000 shares of XYZ stock @ $50 per share you can sell calls against that stock for $500 per contract each month. With 1000 shares you get to sell 10 of those calls for $5000 of total cash-flow. If you do this each month for a year you have generated $60000 in credits on a stock that represents $50000 of value. That’s the power of cash-flow, and remember it’s from a market that you don’t need to find tenants to pay the rents.
When you trade a Covered Call, you take on the obligation to sell your stock at the strike you sell. So what happens if the stock goes up beyond your strike and expires in the money? The market will take your stock and you will have generated your maximum profit potential. If you want to get back into that stock again, then after expiration you will have to buy that stock back.
When we talk about trading rules, it’s important to be specific enough to make sure that traders can execute the trade consistently but have a little wiggle room so that you can adjust for each stock and their corresponding option chain. First, look for companies that are affordable. If you have to put your entire account on 100 shares of stock it may be unwise to do so. Establish a range of price that reflects an affordable range. Second, when selling the call use Out-of-the-Money calls in the delta range between .20 and .50. I suggest starting with calls as close to .40 delta as you can find. The expiration should be between 1-2 months of time. If you build a rule for days instead of expiration month then look for 15 to 75 days of time, with the preference between 30-60 days of time until expiration. You should have a cash flow expectation of 3% or higher in Return on Investment (ROI).
After you get into a Covered Call, you still need to manage the position.
If you’re a swing trader – which I define as someone who would like to get paid either this Friday or next Friday – then place a stop loss on the entire position (stock and call) @ a technical level or your break-even price. If you’re more of a position trader – which I define as someone who wants to get paid by the end of the month – then make sure you’re using a weekly chart to set the stop loss and look for a key support or technical level. If you want to use a % then somewhere between 4-8% is a good range to use from your stock entry point to set the stop loss.
There are more advanced techniques that you can consider with Covered Calls. Hedging by adding a long put option is one consideration. If you don’t want a stop loss, but would rather protect by buying a put option if the stock starts to drop then you need to learn how to set a contingency order to buy the put option. You will also need to learn how to read the risk graph to understand how adding the put option will adjust the overall risk graph.
Another consideration is rolling up, rolling down and rolling out. Many Covered Call traders will choose to buy back the call they sell instead of just getting rid of the entire position. If you buy back the call you sell then you have to consider selling a new call. The best choices are going to be to use a lower strike call in the same expiration month (rolling down) or using another call in a further out expiration month (rolling out).
The entire process of making a Covered Call trade needs to be defined by you as a trader. How do you select stocks? How do you choose which call you sell? Once you sell, how do you manage the position? If you can define these things you are well on your way to building a system with your Covered Call trading.