Options Education

Covered Calls

Concept

We own the stock. We lease someone the right to buy it for more than we paid for it. They'll pay us 8% - 12% per month to do this on certain stocks.

Example: We buy stock for $32, and then sell someone the right to buy it from us for $35, and they pay us $3 for that

You can sell stock you own

• You own the stock and you're ready to sell
• You want to get a little more
• Collect some premium above the current stock price and lock in profits

There are times when an investor is waiting for a pullback in a stock to buy it, but there are also times when one is looking for the stock to increase a few more dollars before selling. If you feel that you are not ready to sell at the current level but would sell if the stock rose a couple of more dollars, then using covered calls to sell stock is a great plan.

In May ABC stock is trading at $67, so let us assume that you bought the stock for a lower price and it is now getting to a price that you would consider selling ($70). You could write the July 70 calls for the current bid of $3.5, collecting $350 in premiums. By writing the calls you are assuming the obligation to sell our stock at $70, which happens to be your target price anyway.

If in July the stock is above $70 you would expect the call to be assigned and you would also keep the premium for which you originally sold the calls; effectively selling the stock for $73.50 per share. It might be easy to second-guess yourself if the stock was up near $80. That is part of investing. But what would have happened if you did not sell the calls? Would you really have sold at $70? How many times have you sold a stock and then watched it rise or held onto a stock you should have sold and watched it fall? Selling a call with the intent to get called out is a great way to get paid to sell a stock you own at a price to which you agree.

Another scenario is for the stock to not rise above $70. The contract will expire worthless, and you keep the premiums collected for selling the contract. Then next month you can turn around and start the whole process over. Let's take a look at that alternative.

You want to use covered calls to generate income.

• Own a strong stock that is currently weak.
• Sell a call as the stock peaks over.
• Repeat the next month.

Writing calls on stock you own to generate income looks like this example. Let's say you own 100 shares of ABC stock, purchased at $38 per share. You notice some possible technical weakness or the stock has been trading sideways for a while and you feel it will likely continue to do so.

You could sell 1 ABC June 40 call at $4. If the stock drops a little, the profit from selling your call will offset your loss on the long stock. If the stock moves to $35 on expiration, you will have lost $3 per share on the stock but made $400 on the expired call. This leaves you with a net profit of $100 even though the stock went down.

By writing calls in this manner, your goal is to pocket the time premium collected from the sale of those contracts, if the options were to expire out of the money. Be aware that you still have the risk of stock being called away if the option is exercised. This will usually take place at expiration when the stock price is above the strike you sold, or in other words, your contracts expire In-the-Money.

If the stock price rises dramatically you will not participate in that rise above the strike that you sold. Depending on your mindset this might not be a bad thing. So your risk in the play is low to moderate.

It's also possible that you have turned very bearish on your stock and its price is dropping faster than you can generate call premiums to offset the loss. In this type of situation you would want to sell your stock. We will deal with this situation specifically in the management section.

This strategy is for stocks you own and are neutral on. If you are extremely bullish on a stock then this strategy is best not used because you may be called away or assigned and you won't participate in the upwards rise of the stock.

Because you are writing or selling contracts, the goal of this play is for the expiration date to come quickly in order that you will soon be out of the obligation to sell your stock. So you want to sell contracts with a short time frame until expiration, preferably less than 30 days.

When you are writing calls with the intent to sell your stock it is OK to write a longer time frame, but not more that two months.

Assignment

When you buy an option you hold the right to exercise the option if and when you choose. By contrast, when you sell an option you assume the obligation of the option if the buyer chooses to exercise. If the option is exercised, you are forced to fulfill the terms of the option. This is known as being assigned.

For example, if you sold 1 XYZ JUN 35 CALL and the option was exercised, you would be assigned and required to sell 100 shares of XYZ to the holder of the call at the $35 strike price, regardless of XYZ's market price. Similarly, if you sold 1 XYZ JUN 45 PUT and it was exercised, you would be required to buy 100 shares of XYZ at $45.

General Sell Guidelines

Sell ATM when slightly bearish

If you are bearish on a stock but are not motivated to sell it outright, you can sell ATM calls to collect a higher premium. If the stock price does rise, you are in effect getting paid to sell your stock, a stock that you were slightly bearish on anyway.

Sell OTM when slightly bullish

If you are slightly bullish, sell the OTM calls by one strike price. This will give you a little cushion if the stock rises. If you do get called out you will be getting paid to sell your stock at a higher price than it is currently trading.

Evaluate the play by using the covered call calculator

This is a very conservative strategy and can be done in a retirement or tax-sheltered account, in fact, it is the only option strategy that you can use in these accounts.

Timing is the key to covered call writing

Trying to write calls for income and not have your stock called away from you takes a bit more skill and timing. It is wise to recognize the bearish or neutral price patterns that you have learned previously to help recognize when a stock is most likely to relax, thus allowing us to keep our premium and our stock, with the anticipation of doing it again next month. It is during the peaks of these patterns that we should look to sell calls. Let's look at a few pattern and talk about ideal times to sell and the possible outcomes.

Sell a short time frame
Any time we see a likely peak in the stock and have anywhere from 30 days to two weeks left until expiration it may be worth our while to consider covered calls.

You must always take into consideration the possibility of the stock dropping so fast that you lose money by holding on to the stock.

And, of course we do have the chance to get exercised or called out. This should not be necessary to mention, and it may seem ridiculous to some, but the number one reason people lose money while using a covered call strategy is that they buy poor stocks at the wrong time. The most ideal time to sell a call is after the underlying stock has gone on a run. It is after a nice healthy run that a stock will most likely relax and consolidate or have a slight pullback. If we do get called out we get the benefits of selling the stock even higher.

Do not buy an individual stock just for the purpose of writing contracts to generate a monthly paycheck. As easy as this strategy seems, people can still lose money. By putting money into a stock with poor fundamentals, you risk the fact that the stock may drop faster than you can generate income from writing and selling contracts.

Think about your objectives with a stock and determine if making a monthly paycheck and cash flow is worth the potential of being called out.

It is not always interesting to make 10% on 500 dollars. It might not even cover your commissions. On the other hand, if you owned 7,000 shares of XYZ even though you are making only 3 or 4 %, you might like the actual dollar amount you can put in your pocket. So it is obvious that every situation is different, but as a general rule achieving about 5% on a covered call play is a pretty good return for tying up your stock for a few weeks.

In conjunction with this, one of the keys to successful covered call writing is the value of the premium you will collect per contract relative to how many shares you own. As a general rule if you can collect about a $1 premium for a one strike price OTM contract, you are going to be very pleased, but as low as .50 to .60 cents can still be worth your while if you own enough shares. Of course, the premiums collected will be relative to the stock price that you own. Higher options premiums are usually associated with more volatile stocks.

If the stock price remains constant as time passes, an option premium will decrease in value. This principal works in your favor if you have already sold contracts, but can work against you if are trying to sell contracts for that monthly paycheck. So what is the ideal time frame? Usually about 25 to 15 days, but there is no rule that says you can't sell contracts with 30 or 35 days remaining until expiration if the opportunity presents itself and you are comfortable with the potential outcome versus your possible gain. Also, there is no rule that says you cannot sell with even less than 2 days left until expiration, provided you can be profitable depending on the outlook of the stock.

You can use this strategy to get paid to sell your stock, particularly if you bought a stock at $43 and it now has gone on a nice run to $50 and you feel comfortable selling at $50 even though there may be a slight possibility of more upside. You can get paid (in the form of collected premiums) to sell at that level by writing the contract. If the stock drops, you now have some extra income to make up for the slight loss in stock value. In other words, you made money anyway. If the stock continues to rise, then you will get called out of the stock at $50. This is not a bad thing since you were thinking about selling at that level anyway, but now you got paid to do so.

This can be a good strategy for Exchange Traded Funds (ETF) investors as well. This strategy can also be combined with the ownership of LEAPS contracts to create what is called a calendar or time spread to generate some great returns.

Warning: The covered call differs from writing an uncovered or naked call in that an uncovered call does not involve the ownership of shares of the underlying stock. Selling uncovered calls is considered highly risky and is not recommended for anyone but the most advanced options investor.

Risk Management

Rapid rise in stock and you do not want to get called out.

Our primary management concern comes up when the underlying stock has run up and we have decided that we do not want to get called out of our stock. If this is the case we need to buy back and close our contract before the expiration date. We will buy back the same type of contract we sold. If we sold a contract on XYZ stock with an expiration date in March and a 50 level strike, then we need to buy back a contract that expires in March with a 50 level strike. This will close our position and we will no longer be obligated to sell our stock.

We will have to pay more for it than we sold it for because now the stock price has risen in value. But we can use the money from the original sale of the contract to help in the purchase. There is a slight chance that we can have early exercise of a contact we have sold. This is when the party to whom we sold the contract exercises his rights before the expiration date. This is very rare, but can happen on occasion.

Rapid decrease in stock and you want to sell your stock.

The second concern is when our stock is dropping rapidly and we want to get out of the stock but we are still under obligation. We cannot sell our stock until our obligation to the contract has expired, even though the contract has now decreased in value and the odds of it being exercised are extremely unlikely. This is a scenario that can occur when you sell a covered call and it is something that you must consider. The stock that you bought may get bad news, the industry may fall out of favor, or the market may get bad news and your stock begins to plummet and you want out.

You must watch out for this, because you cannot just sell your stock if it starts going down, as you are obligated to sell your stock to someone else if they so choose. Now, they will obviously not choose to buy the stock, but the fact remains that you are obligated. You need to buy back (buy to close) the call you sold. For example, if you sold the January $50 call option, you put an order in to buy to close the January $50 call option on XYZ stock. Once this transaction is complete, you can sell your stock because you are out from under the obligation.