Learn to Trade Options: Uncovering Covered Calls

Breaking down options strategies with options guru, Bernie Schaeffer

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    Trading options can be a complicated process as a lot of options strategies are available and traders need to evaluate all of the possible routes ahead of executing a trade. As such, Schaeffer's are starting a new educational series titled Optimizing Your Options Strategies. The beauty of options trading is that there are options strategies for every market environment. In this series, we will cover all available options strategies for an educated trader to consider when identifying trading opportunities.

    In this article, we will be talking about one of the most popular options strategies known as Covered Calls.  A covered call is a strategy involving trades in both the underlying stock and a call option. The trader buys, or owns, the underlying stock. The trader will then sell call options (the right to purchase the underlying asset or shares of it) and then wait for the options contract to be exercised, or to expire. If an options contract is exercised when trading covered calls, the trader will sell the option at the strike price, and if the option contract is not exercised, the trader will keep the stock.

    When implementing the covered call strategy, the call that is sold is typically out-of-the-money (OTM), which means that the option strike price is higher than the current market price of the underlying stock. This allows for profit to be made on both the call option writing and the stock if the stock price stays below the call option’s strike price.

    On the contrary, a covered call can also be executed when a trader believes that a company's stock price will go down and still wants to maintain his position in the underlying stock through the sale of an in-the-money (ITM) call option, where the strike price of the call option is below the current market price of the underlying asset. When selling an ITM option, a trader will generally receive a higher premium, but that comes with a risk that if the price of the underlying asset doesn’t fall below the ITM strike price, the buyer of the call option can exercise their call option, and then the call buyer will be entitled to the stock position.

    The covered call options strategy can be a great tool for long-term investors and traders, but it is rarely used by day traders because of its margin requirements. The risk of a covered call comes from holding the underlying asset which could drop in price. The maximum loss will occur if the stock itself goes down to zero.

    Maximum Loss = Stock Entry Price – Option Premium Received

    For example, if a trader buys a stock at $5 and receives a $0.10 option premium on his sold call, his maximum loss is $4.90 per share. The money from his option premium reduces his maximum loss because he owns the underlying stock. The option premium income comes at a cost, though, as it also limits a trader's potential upside on the stock. One could only profit on a covered call strategy if the stock is above the strike price of the options contracts that were sold. The maximum profit is limited in this strategy, and can be calculated by using the formula:

    Maximum Profit = (Strike Price – Stock Entry Price) + Option Premium Received

    For example, if a trader buys a stock at $5 and receives a $0.10 option premium from selling a $5.50 strike price call, then he maintains his stock position as long as the stock price stays below $5.50 at expiration. If the stock price moves to $6, he can only profit up to $5.50, so his profit is $5.50 - $5.00 + $0.10 = $0.60. If one were to sell an ITM call option, the underlying stock price will need to fall substantially for one to even hold on to his stocks. If that occurs, the trader will likely be facing a big loss on his stock position. However, this loss would be offset with the premium received from selling the call option.

    The primary objective behind the covered call strategy is to collect the call option premium by selling calls against the stock that are already in a trader's portfolio. Choosing covered calls out of all available options strategies can be a great way to earn income on existing stocks in one's portfolio. Assuming that the stock does not move above the strike price of the call option, the trader gets to collect the premium and maintain his current stock position. Traders should also factor in the commissions when trading the covered call options strategies. Consider a brokerage that offers commission-free trading.

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