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?