Covered Call

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A Covered Call is a financial position in which you own an underlying asset, and write, or short a call option on the underlying. In other words, you have sold to the buyer the right to purchase an asset from you, but you also own the asset in the event that they exercise the call option. A quick example would help illustrate the point. You short a call option on 100 shares of Company Z, but you also currently own 100 shares of Company Z. If the call is exercised, you deliver the 100 shares and receive the strike price. Conversely, if it is not exercised, you keep the shares of the company, and you also earn the price you charged for selling the call (often times referred to as the call premium).

Covered call writers should be aware of volatility's effect on their short option position. An increase in implied volatility will make it more expensive in the event that the investor wishes to "buy back" the option prior to expiration.

Covered Call Strategies

There are two common ways to use covered calls:

  1. Buy-write: A buy-write (or buy-and-write) is the purchase of the stock and immediate sale of the call option. It is the immediate sale of the call that sets this tactic apart from the legging-in strategy. Most retail brokerage platforms offer the trader the ability to enter both orders (long stock/short option) all at once. The index that charts this strategy for the S&P 500 is BXY (see image at bottom).
  1. Leg-in: Legging in to the covered call means purchasing the stock and in a later transaction selling the call. This tactic implies that the trader can time his/her way into the short option position sometime in the future for a higher profit than if they simply did a buy-write.

8 Ways to Profit from Covered Calls

The covered call trade has always been known as an income strategy as you receive premium for selling calls against your stock. This is the most popular rationale for implementing this type of tradings. However, there are many more dimensions that can be coupled with covered call trading to further enhance the potential for profits. Here is a list of 8 ways to profit from covered calls:

1. Selling the classic covered call against stock you own. You make money with the time decay of the short call. usually you sell the near month or next month out so you can continue to compound your money.

2. You can use LEAPs as stock replacement to leverage a covered call trade which will increase potential profit returns. Click here for a recent article on this topic.

3. You can sell out-of-the-money (OTM) calls as your short call. Here you get the call premium and potential for a capital gain as the OTM call offers some upside profits for the stock price to increase.

4. You can make more money on a short call when volatility collaspse early in the trade and you close the trade. We have all been in covered call trades when after a few days the call option loses value and you find yourself in a very profitable trade. You can close this short call to lock in profits.

5. You can trade the short call as the stock price changes. For example, if the stock price decreases, you can close the short option early for a profit. Then, the call can be written again when the stock prices snaps back to higher levels. This is similar to channeling stocks by trading the short call against stock price changes.

6. You can roll up or roll out the short calls to a higher strike price or to a later expiration month. This allows you to squeeze extra profits out of a stock price rise.

7. You can add option legs to a short call to create spread positions such as a bull or bear call spread. This is good to take profits from a rising covered call trade or a falling stock price.

8. You can add a long protective put to the covered call position as it will increase in value as the stock price decreases. This is usually utilized as protection against stock declines but can create more income when a stock price declines while you are holding a covered call position.

--Gregp123 11:48, October 27, 2011 (PDT)--Gregp123 11:48, October 27, 2011 (PDT) Get Rich Investments: Investing for Income.


How to Use Volatility with Covered Call Trades

There are two types of volatility used in security analysis: historical volatility measures the past price movements and implied volatility that indicates the potential level of future volatility a security is implying.

Historical volatility (HV) is the price changes of a security over a period of time so it is really a standard deviation calculation. This means it is how much a stock price has moved over time usually expressed as a 10-day or 30-day volatility. For example, a stock with a volatility of 70% is high and should be considered quite volatile. This is not the type of stock to write a covered call on. In contrast, a stock with a volatility of 20% is a low volatility stock and selectable for a covered call.

The stock’s volatility can help us forecast short-term price ranges and the relative value for an option price. The option premiums of highly volatile stocks will have a high value while a low volatility stock will have a much lower premium. An options premium will be influenced by the probability the stock price will move above or below the various strike prices. Of course, the excitement of high premiums leads to some investors falling into the premium trap by chasing highly volatile stocks that impose a significant risk to loss of capital.

Another thing to keep in mind is the stock volatility as a confirmation of the stock chart. Suppose you are looking at a stock chart that seems to be in a trading price range that is stable. The 30-day historical volatility is 72%. Is this a good stock candidate for a covered write? The correct answer is no if you are seeking a conservative covered call investment. Compare the 72% volatility to a stock with a 30 day HV of 25% which is lower than the S&P 500 at the same time. I would select the stock with a 25% 30 day volatility for a more conservative covered call investment.

The bottom line is that adding volatiliy to your covered call selection process will increase your chances of morw winning trades and a more consistant income stream. There will be several more posts about volatility in covered call investing in the coming days.

--Gregp123 12:27, October 27, 2011 (PDT)

What are the uses of covered calls?

Because an investor who takes a covered call position has the underlying asset, in the event the buyer of the call option exercises he can deliver with certainty. Therefore, investors sell short-term call contracts (usually monthly) against their underlying securities as a means of generating income while owning the shares. This allows them to earn money even if the asset value does not increase. For instance, suppose you bought 100 shares of Company X at $10 per share. You then sell a call option for $1 against those 100 shares with a strike price of $12. As long as the price of the stock remains below $12, you get to keep the shares as well as the $1. If the price of Company X stock stays at $10 all the way until the call option expires, then you have generated $1, yet you still own the stock. However, if the stock price rises to $14, then the stock is called away, and you earn only the $12 strike price and the $1 premium for selling the call.


Potential pitfalls of covered calls

A major pitfall of covered calls involves writing the call with a strike price below the cost basis (cost basis means the cost to you of acquiring the shares). If your shares are called away, and the premium plus cost basis is not equal to or greater than the strike, you are guaranteed a loss on the position. For example, you paid $1000 in total for 100 shares of Company X ($10 per share), and you sold a call option on these 100 shares with a strike price of $9 per share. If you do not charge more than $1 for the call option, you are guaranteed a loss in the event they are called away since they pay only $9 per share ($900 total), and you are earning less than $100 for selling the call. If the shares fall below $9, you will suffer a loss since in total you will receive less than $1000, which is the price you paid for the shares.

Payoff

External Links

Born To Sell covered call screener

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