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Covered Calls explained

 

If you’re a newcomer to Options, but are familiar with investing in Stocks, the “Covered Call” should be one of the first strategies you should learn. Covered Calls can be a safe strategy to create income on stocks you already own. Ideally, you should be able to achieve a return of 1% every 15 days or about 2% a month. The key elements of a covered call are as follows –

 

1)   You already own the stock, and you’re prepared to hold the stock for some time, but if a good opportunity comes up to sell at much higher prices, you’re fine with that. Meanwhile, while you’re holding the stock, you can create income on a regular basis from this stock.

 

2)   You sell an OTM Call option and receive premium. Ideal timeframe left for expiry is about 15 to 20 days. This will allow for a “rinse and repeat” operation every 2 weeks. The amount of contracts you sell must be equivalent to the number of stock you hold. For example, if you hold 100 shares, you should sell 1 contract. If you hold 1000 shares, you should sell 10 contracts. (1 contract = 100 shares in the Options world).

 

3)   This is why this strategy is called a “Covered” call. The Call Options you sell is covered by the stock you own. If you were to sell Naked Call options, you’d be required to post a much larger margin by your broker. But because you own the stock already, your margin (and the risk assessed by the broker) will be minimal.

 

Let’s take a real example with Apple (AAPL) Options. If you own 100 shares of AAPL (perhaps you bought it at $620 and you already have a profit), and the figure below shows AAPL is currently trading at around $665 on Oct 3, 2012. The October expiry series has 16 days to expiry. The Call Option at the 690 strike price is going for a premium of 6.30, which is roughly 1% of the stock price. You sell this Call option against your stock (Your broker platform should automatically recognize this is a covered call and will not margin the trade as a naked call. If it doesn’t, you should change your broker).

 

 

 

 

These are the following scenarios in 16 days on the day of expiry –

 

1)   AAPL does not move much. AAPL finishes the series somewhere between 660 and 670, so your 690 Call expires worthless. The premium of $6.3 per share that you collected is yours to keep. Nice, you move into the next series and “rinse and repeat” maybe at the same strike or even go to the 700 strike price.

 

2)   AAPL closes at 692. You will be assigned on your 690 Call Option, so you are obligated to sell your shares at 690. You get to keep the premium of $6.3, but you have to pay the intrinsic value of the Option which is $2 (692 – 690). So your total profit was (690 – 620 + 6.3 – 2) = 74.3. You got to sell your shares at 690, which is far higher than its current price of 665 plus a portion of the premium. Not a bad deal at all.

 

3)   AAPL closes at 650. You get to keep the premium of $6.3 and your shares,  which you were prepared to hold anyway. Rinse and repeat for the next series, perhaps at the 680 strike price this time.

 

All in all, the covered call is a win-win strategy if you want to hold the shares anyway. Every series that you collect premium, you are reducing the cost basis of your stock. The first month you have reduced your cost basis by $6.3, the next month you may reduce it some more, and so on. The downsides to watch for in this strategy is if AAPL rises above 696.3 or if AAPL falls too hard to say 630. If you feel AAPL is likely to go above 696, then you buy back the Call Option and let the stock make its profits. If you feel AAPL is going to crash, then it may be best to close out the whole position. Would welcome your questions or comments on this strategy.

5 Comments

  • I fully agree; I routinelly use the covered call strategy with dividends paying stocks to provide an acceptable income for “bond invetors” in today low interest environment.
    The choice of th stocks and the calls to write is obviously the most critical part of the strategy. I will give you an example NOT A RECOMMENDATION with CAT (Caterpillar). The company pays $0.52/Q and goes ex dividend on @10/20. The stock is tradin@ $86; by the stock and sell a January 100 Call for @$0.74. You will receive $$1.78 ($0.52×2+$0.74) cash in your account, for a yield of @2% in four months equivalent to a @6% annualized yield witout considering commissions. If CAT by January is above $100 the calls can be rolled up; but if you prefer to be assigne or are assigned, the return would be @18% in four months.

    Anybody interested in learning more e-mail me.

  • Hi Bill,

    Your example is a bit more advanced, my post was intended to be a basic intro into covered calls – But yes, your strategy can be creatively applied to increase your returns. And the best part – this is a fairly safe strategy..Thx for pitching in

  • A more advanced variant of this strategy is using long further out deep ITM calls as a proxy for the actual stock and then writing “covered” calls against it. When it comes to the likes of AAPL, GOOG, etc.,, this strategy yields high returns, because of the heavy extrinsic (time) value associated with the short calls.

    • Amol, and not to mention your strategy involves less capital because you’re buying deep ITM calls as opposed to the stock itself. Its a great strategy, but a little advanced. Glad you pointed this out..

  • I use some technical analysis tools to buy a stock at an attractive price. And if i want to hold it for the long term i combine it with covered calls. The risk is you can get called away if the stock rises too fast