A Complete Breakdown of How to Trade Covered Calls

Covered calls are one of the best ways to introduce yourself to the world of options

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    The covered call options strategy is available when you own 100 shares of a stock and then promise to sell your shares by writing a call option. In exchange for promising to sell your shares, you are paid a premium by the call buyer. The covered call strategy is often used within retirement accounts to generate income and act as a hedge to downward moves in stocks.

    The covered call is generally the first option strategy long-term investors use because the only risk added to the portfolio is potentially being forced to sell their shares at a higher price. Covered calls are also typically the first level of options that will be approved by a broker on a trading account. While this strategy may not be the greatest fit for a younger investor, people who are nearing retirement might welcome this sale of their stock, especially when they collect income on top of the sale of the stock.

    A Simple Example of a Covered Call

    Covered calls can be a bit confusing to wrap your head around at first, but it is quite an easy strategy to use. To simplify this strategy, let’s look at an example using the stock AAPL.

    Let’s assume that you own 100 shares of AAPL stock at $100 per share. You can sell a $120 strike call on AAPL that expires in 30 days and receive $100 ($1 per share) in premium. No additional money is tied up to make this trade, but you are obligated to sell your shares at $120 even if it goes higher than this.

    Two things can happen after placing this trade: 1) AAPL stays below $120 at the end of 30 days, and you keep your shares and the $100 as income or 2) AAPL goes above $120 per share at the expiration date, and you are forced to sell your 100 shares at $120 per share and still get to keep the $100 income.

    Regardless of the scenario, you get to keep the $100 as income in your account, as if it was an unqualified dividend payment

    The Downside to Selling Covered Calls

    When learning about any type of options strategy, you must be aware of any additional risks you are taking with your portfolio. Covered calls do not require any additional capital, given that you have 100 shares or more of a company in your account, but this does not mean there is no risk added. The worst thing that can happen when you sell a call is the stock goes far above the strike price at which you promised to sell your shares.

    So, with our example, let’s say that AAPL went all the way up to $200 and you were short a $120 strike call. You would miss out on $80 per share worth of gains. Sure, you still make money, but when you look inside your account, you will see a huge unrealized loss on the call option that you sold. So, to recap, your account value went up, but you still lost money by selling the call option. You just made more on the shares you own to cover the losses on the call.

    Important Takeaways Before Trading Covered Calls

    Learning how to trade the covered call is one of the best ways to introduce yourself to the world of options. Whether or not you decide to use them actively, understanding the opportunities involved can be a game-changer for your portfolio. This strategy can be very useful when you are long 100 shares of stock, and you believe that the stock is overvalued but you do not want to sell any of your shares.

    If you decide to sell a covered call and you are right and the stock falls then you hedge yourself on the way down and receive some cash to potentially buy more shares. Even if you are wrong and the stock continues up there is a good chance that you are still going to make money. Option selling strategies generally do not require you to be great about picking a direction in which the stock will move since you are receiving income regardless of what happens.

     




     
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