When I talk to traders, I tend to ask them if they understand options.
About 75% of the time regardless of their experience with stocks, most traders know little to nothing about options.
Options can be very intimidating, but, when they are understood properly, they unlock a brand new world of income generation.
Options act like cheat codes in video games.
Sure, you can play the newest game, but it is so much better with those codes.
There are many different strategies for options investors, and not every strategy is suitable for every trader.
In this article, you will get a step-by-step on how to accomplish selling your first covered call.
I expect if you are reading this, you have already mastered the art of buying and selling stocks and have some positions you’ve held for a long time. Unless you are strictly looking for dividends, you probably expected the stock price to rise to sell it for a profit.
Many investors who get started trading options fall into a simple trap, buying long calls.
Long calls are great for speculative plays, but end up being a major disappointment since time works against the buyer of an option contract.
The best way for most stock traders to get started trading options happens to be selling something called a covered call.
Find a stock position where you have at least 300-400 shares, the more the better. It would be best to find a stock that is already trading for more than you paid and also does not pay dividends. Large dividend payers add an additional element that I won’t be covering here.
Consider Selling a Covered Call
Another way to potentially accomplish your goal of making an options trade and also generating a larger profit from your holding would be to sell one covered call.
Simply put, a covered call is a strategy, investors can use to generate income from their existing stock holdings. You sell one contract worth 100 shares of stock. That is why for your first covered call, you should have at least 300 shares.
In exchange for selling the call option, you receive option premium.
That premium you just collected comes with an obligation because you are now the seller of an option contract.
If that call option is exercised by the buyer, you may be obligated to deliver your shares of the underlying stock. Since you own the stock, you are covered, hence the name covered call.
Here Is How Selling a Covered Call Works
- In March, you own 100 shares of ABC, which is currently trading at $50 a share.
- You sell one covered call with a strike price of $53 and an expiration date of June. The bid price (the premium) for this option is $1.25.
- Suppose you then said to yourself: “I’d like to sell one covered call for ABC June 53 for a limit price of $1.25 good for the day only.” Hint: It’s suggested you place a limit order, not a market order, so that you can specify the minimum price at which you would be willing to sell.
- If the call is sold at $1.25, the premium you receive is $125 (100 shares x $1.25) less commission.
- Now that you sold your first covered call, you simply monitor the underlying stock until the June expiration date.
The reason for writing calls is you hope to keep the shares while generating extra income off of the premium. You will want to stock price to remain under the strike price you sold the call contract for and if that happens you keep the premium and the stock.
Smart option traders will also take money off of the table in the middle of a trade, meaning if the stock you hold gets hit hard, and sells off, the value of that call will drop.
Many times, even in my own trading, I would rather close out the position without keeping the entire premium.
Stocks generally trade between their support and resistance, and if you are a patient investor, which I know you are, you will do very well with covered calls.
What Could Go Right or Wrong Selling Covered Calls
Example 1: The underlying stock, ABC, is above the $53 strike price on the expiration date.
If the underlying stock rises above the strike price any time before expiration, even by a penny, the stock will most likely be “called away” from you. In options terminology, this means you are assigned an exercise notice. You are obligated to sell the stock at the strike price (at $53 in this example). If you sell covered calls, you should plan to have your stock sold. Fortunately, after it’s sold, you can always buy the stock back and sell covered calls on it the following month.
One of the criticisms of selling covered calls is there is limited gain. In other words, if ABC suddenly zoomed to $57 a share at expiration, the stock would still be sold at $53 (the strike price). You would not participate in the gains past the strike price. If you are looking to make relatively big gains in a short period of time, then selling covered calls may not be an ideal strategy.
Benefit: You keep the premium, stock gains up to the strike price, and accrued dividends.
Risk: You lose out on potential gains past the strike price. In addition, your stock is tied up until the expiration date.
Hint: Choose from your existing underlying stocks on which you are slightly bullish long-term but not short-term, and are not expected to be too volatile until the option expires.
Example 2: The underlying stock is below the strike price on the expiration date.
If the underlying stock is below $53 a share (the strike price) at all times before expiration, the option expires unexercised and you keep the stock and the premium. You could also sell another covered call for a later month. Although some people hope their stock goes down so they can keep the stock and collect the premium, be careful what you wish for.
For example, if ABC drops a lot, for example, from $50 to $45 a share, although the $125 premium you receive will reduce the pain, you still lost $500 on the underlying stock.
Benefit: The premium will in all likelihood reduce, but not eliminate, stock losses.
Risk: You lose money on the underlying stock when it falls.
Advanced note: If you are worried that the underlying stock might fall in the near term but are confident in the longer term prospects for the stock, you can always initiate a collar. That is, you can buy something called a protective put on the covered call, allowing you to sell the stock at a set price, no matter how far the markets drop.
Example 3: The underlying stock is near the strike price on the expiration date.
Some might say this is the best case scenario for a covered call. If the underlying stock is slightly below the strike price at expiration, you keep the premium and the stock. You can then sell a covered call for the following month, bringing in extra income. If, however, the stock rises above the strike price at expiration by even a penny, the option will most likely be called away.
Benefit: You may be able to keep the stock and premium, and continue to sell calls on the same stock.
Risk: The stock falls, costing you money. Or it rises, and your option is exercised.