How I use covered calls.

Learning about options was one of my 2105 goals. A covered call was my first choice to start my option journey. Via a series of articles, I plan to document my journey in options, not only for myself but also to help others.

This article focuses on how to use covered calls.

How do covered calls work?

What is a covered call? A covered call is an investment technique whereby you own a stock and decide to write a call on this stock. Now, what does this mean? By writing a call

  • You are obliged
  • to deliver – sell
  • the underlying stock
  • in exchange for an agreed price – the strike price
  • This obligation lasts until the expiration date of the option
  • In exchange for this promise, you get a premium

So, what is a covered call? It means that you already have the underlying stock in your possession. As such, you do not need to worry about how/where you will find the stock that you need to sell: you already have it.

Let’s look at a concrete example:

Assume that you have already own 100 stock of RDS.A. You can now write (sell-to-open) 1 RD.C.16SEP16.AEX.AM.25. Or, you are short the call. This means that you now are obliged to sell 100 stock of RDS.A at the price of 25 EUR when you are asked to do so. Even if at that time, the stocks is traded for 30 EUR. This obligation lasts until 16 September 2016. For this, you will get a premium. Note that in the mean time, your broker will reserve the 100 RDS.A shares. This means you can not sell them as long as you are short the call.

Why would you write a covered call?

Why would you be willing to sell a stock at 25 when it trades at 30? Good question… It sounds crazy… At first… Let me try to explain

In the case above, imagine you have bought the stock at 20EUR. You are happy to sell at 25 or with the 5 EUR (or 25pct) return on the stock. By writing the covered call, you can increase your return with the extra premium. The downside is that you can not sell higher than 25.

So, where is the upside? If the stock does not reach 25 by Sept 16 2016, then you get to keep the premium and you can start all over again. And while you are waiting, you also get the dividend. You can see the premium as a real boost on your return.

And what if the stock drops to  18 and you want to sell? In that case you will have to first free up the stock by buying back the option and then you can sell the stock. Due to the nature of options, you should be able to buy back the option for less than you sold it.

The different scenarios of selling covered calls.

The price goes up and beyond the strike price.

In this case, you are very likely to be assigned close to expiration (in some cases, even sooner). This means that you need to deliver on your promise. You will have to sell the stock at the strike price. You get to keep the premium received as extra return on your stock. If you really wanted to keep the stock, then you should not have sold the call.

The price does not move or stays below the strike price

You get to keep the premium and you get another go to write a covered call to make some extra return.

The price goes down

In this case, you have the premium that could off set the potential loss. You can write another call if you want. Remember, as long you are short the call, you can not sell the stock.

Do you use covered calls?

Before entering into option trading, educate yourself in the risk of trading options. Most brokers have a test that allows you to determine if you have the right knowledge and experience to do so. Why not consider paper trading for a while?

 

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14 thoughts on “How I use covered calls.

  1. Ciao ATL,

    Must look into this system, I have several stocks that I want to sell, but I keep postponing for several reasons. The example where you already have “gain” and you set a price to get the premium and that gain is quite interesting, could effectively means that you get a double gain from the sale. If the price goes down at least you’ve got the premium… (and still hold the stock that in our case is a dividend stock anyhow so it’s not so much of a tragedy…) How much is the premium normally?

    Like

    1. Hey Stalflare,

      Good that you get some interest…

      To answer the question: how much is the premium… this is difficult as it depends on a few parameters. 3 important ones are
      1- volatility: what view has the market on the swings there will be. For now, this is in general quite high
      2- duration: do you want the option for a month, 2 months? Accoriding to tastytrade the sweetspot is 4 days
      3- current price of the stock: you get more premium on a stock of 100EUR than on a stock of 30 EUR.

      So, it all depends on what you want to achieve.

      Liked by 1 person

        1. Points to consider:
          Do I really want to sell the stock at the strike price, even if the markets recovers the next month?
          What are the tax implications? (We have some silly tax rules in Belgium)
          How much is the transaction cost compared to the premium received?
          Do I have a multiple of 100 stocks (options usually are contracts for 100 stock, check what is the case for your stock. So, If you get a premium of 0,4EUR for the option, in reality, you get 40 EUR and need to have 100 stock)
          If the stock drops further, am I hapy to keep it? (or buy back the option and then sell)

          Enjoy the reseach.

          Like

          1. Ciao ATL, Thanks for the heads up, the first problem that I seem to have is that the bank that I use to trade basically requires me to install a (non free) software to do this king of trading… Already some costs, don’t like that. All the rest is quite ok, there are 3 stocks that I can “do without”, but that have good yields. If they fall, I am fine with that, will buy more, if they stay where they are or rise it’s fine to sell them and realise the profit, and get a premium through the warrant… But I have to see costs and taxes… 😛 thanks for the help!

            Stal

            Liked by 1 person

    1. Thx for dropping by…
      As I work for a broker and want to keep this blog and my professional activities separated, I will not answer that question. Sorry for that.

      Enjoy the Belgian stocks.

      Like

  2. I just did my first options trades this year. Sold long term puts on BP, Starbucks and GE….just to test the water.

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  3. I know many dividend bloggers are using options either via covered calls or writing puts to generate extra income via premiums received. The idea looks interesting and for a long time I have wanted to get my feet wet with options but I still do not feel 100% comfortable trying yet. Writing puts could be a good way to buy stocks if assigned and covered calls a good way to sell and lock in a profit or keep the premium received. Look forward to following your options experiences in 2016.

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  4. I started selling covered calls and cash secured puts last year. I think options are a great way to increase total returns or reduce a stock cost basis. I try to buy stocks in lots of 100 shares so I have the option of selling options :-).

    Like

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