what is a Covered Call option trade? How to use Covered Call as an Income Strategy? How does Covered Call work…answers to these and other questions below.
Covered Call is an Income strategy which is easy to understand and implement. It provides extra income while also reducing the cost of owning the stock. This strategy should be part of any investor/trader’s core game plan.
What is Covered Call?
you buy a stock today for $100
and today, you enter into an agreement with someone to sell the stock for $105 in the next 30 days. Buyer pays you a fee of $2.00 for your promise to sell.
that’s pretty much it for covered call. Nah, don’t worry, the rest of the article is not about to banish this view.
Covered Call as an Income Strategy?
In the above example, it was pretty clear that you get paid for a promise to sell at a higher price.
what is wrong with that?
If you buy quality stocks and etfs, i would encourage you to look at Covered Call to generate additional income. You may not need the extra money – but this premium collected would bring down your overall cost of owning the stock/etf.
How to write Covered Call?
almost all broking platforms today have built in option to write Covered Call as one order with the click of a button. i.e buy the stock and sell the promise [to give the stock away at higher price] for a fee.
look around your broking platform or talk to your stock broker for more details on placing the Covered Call Trade.
How does Covered Call work?
as explained in the example above, the concept is simple – you buy stock today and promise (today) to sell the stock at a higher price in the next 30 days. your promise to sell comes for a fee that you receive instantly. This is cash you get in your account TODAY !
again, this reduces your cost of purchase of the stock. OR the put in another way, this fee received will help with downside protection.
What is the payoff in Covered Call?
well, for the fee that you collected upfront, you are giving away your right to enjoy any upward stock move in the next 30 days.
carrying along with the above example, if your stock purchased at $100 zoomed up to $200 – you won’t get to enjoy the profit. As you agreed to sell the stock at $105 – your profit stops there.
to me, the occasions of stock zooming up right after I purchased it – is rare or has never happened. On the contrary, a lot many times, right after I took the stock, the direction seemed to have turned downside !
I wouldn’t mind giving up the right to “unlimited upside” for 30 days for a small fee.
In The Money Covered Call?
some advanced investors/analysts also use In-The-Money Covered call strategy.
this to me is an approach to protect downside and wanting to let go of the stock.
continuing with the above example numbers, if you were to sell ITM Covered Call, here’s how the simple explanation would look like:
you buy a stock today for $100
and today, you enter into an agreement with someone to sell the stock for $98 in the next 30 days. Buyer pays you a fee of $6.00 for your promise to sell.
so, you bought stock $100, you promise to sell in the next 30 days for $98. And you got $6.00 for this promise to sell deal.
Let’s look at this in detail:
why would you do this kind of deal?
well, you are afraid the stock can come down. The promise to sell gets you $6.00 – which is a great deal of protection to the downside.
you are pretty sure that the upside of the stock is capped for the next 30days.
you want to take advantage of the high fees (premium) going around for the promise to sell.
Good Income stream due to high fees (premium)
let us break down the numbers:
stock purchase $100 – fees received $6.00 = $94 (actual cost);
promise to sell $98
actual cost $94
profit on being assigned = $4.00
4% return for the next 30days with 6% downside protection. Pretty sweet deal.
Stock goes to $150 – your profit capped at $4. you will rue the opportunity lost, i won’t if I were you.
Best Covered Call Strategy?
the best bet is to stay with the performers and not be a contrarian. Strategy/guidelines listed below:
stay with quality stocks or better start with ETFs
glance through the stock movement – steady rise is most preferable. don’t get too technical with the charts. Your aim is monthly income.
look at monthly movement of the stock. select a strike and look at the ongoing premium. Is the premium worth your time?
yes, go ahead and sell the Covered Call.
monitor or set alerts on your phone for stock levels should a black swan event happen.
Are Covered Call ETFs any good?
NO. It’s like outsourcing the Covered Call strategy to an ETF guy.
the problem is – Management Fees and Transaction cost eat into your potential profit.
you are better off DIY and taking advantage of tax breaks available on Covered Call Strategy.
Adjustment to Covered Call?
Covered Calls are like any other instruments, you can sell and buy back the same day or the next day or in a few days. No restrictions.
you see profit and don’t want to continue – logon on to your broking platform/app and close the trade.
you fear the option can be exercised – or want to take part in the stock upside – buy back your promise (for profit/loss).
made money on the first month – rinse and repeat. keep the stock and sell the promise to the next higher strike for the next 30 days.
Covered Call and Long Put?
well, the long Put is to protect yourself from stock plummeting.
you do this, buy buying a PUT option using the fees you collected from selling the CALL option. this reduces your return or monthly income.
this is used by investors paranoid about market/stock crash.
IF this appeals to you – go ahead and purchase a put for protection.
One fine tuning of this strategy is that:
you buy stock – with intention to hold it long term.
you also buy a long dated PUT Option – with intention to protect downside for the next 1 year.
and then, you keep selling CALL option each month for a strike price above your purchase.
this modified strategy will cost you upfront as the long dated PUT option would be costly.
Covered Call option strategy is one of the best strategies any active investor/trader should have as part of their stock market hustle.
Yes, this strategy requires a bit of a learning curve, practice and patience. But, the payoff is regular income, lower cost of stock and peace of mind.
Decide if Option trading is worth your time.
if you are interested in getting started with Covered Call strategy – have a look at the recommended books below from Amazon.
also, if you like this article, consider sharing. Also, check out other useful resources in the toolkit section.