Covered Call (Option Strategy) Explained
Covered Call
Definition: A covered call consists of selling an out-of-the-money (OTM) or at-the-money (ATM) call option against a long stock position. Each call sold must be against 100 shares of stock you already own to be considered “covered”. Covered calls limit upside profitability, but the premium collected lowers the cost basis of the long stock position.
Setup
1. Buy/own 100 shares of stock
2. Sell 1 call for every 100 shares of stock (either ATM or OTM)
Risk: Defined. If the call option is exercised by the buyer and you are forced to sell 100 shares at the strike price, we don’t have to worry about unlimited losses due to theoretical unlimited upside in the stock price.
Order Entry: Credit. You are getting paid the premium of the call option. The goal is to either have the option is expire worthless or buy it back when it is worth less than you sold it for.
Direction: Bullish/Neutral. You want the stock to either stay relatively flat or go up.
Ideal Environment: High IV. Since you are selling the option, you want to sell in an environment where options are more expensive relative to their historical pricing and volatility.
Profit Target: 50%. This is the target we use at Mainstreetwolf (MSW) to lock in gains to keep our emotions out of it and be more efficient with using our capital.
Scenario Analysis
So now that we have established from a technical definition and setup viewpoint what a covered call is, let’s discuss the scenarios that can play out in a real-life situation.
For example, we have stock XYZ that trades at $20. We own 100 shares of XYZ. We sell a $23 strike price call option with 30 days-till-expiration (DTE) for $100. How can selling this covered call play out? (All scenarios assuming 0 commissions and kept to expiration to make explanations simpler to understand)
Max Profit – Stock Price goes above Strike Price
Great news has kept coming out and the stock rockets to $28 by the end of the 30 days! The buyer of the option who has the right to exercise that option at $23 would want to do that since now they can buy 100 shares at $23 instead of current price of $28.
Once the option is exercised, the call seller is required to sell 100 shares per call at the specified strike price of $23. In the case of a covered call, the call seller already owns the shares, so they still make money on the shares as well up to the strike price.
In this situation, the trade is closed out at max profit once the shares are called away.
Max Profit = ((Strike Price – Purchased Stock Price) X Number of Shares) + Call Premium.
$400 = (($23-$20) x 100 shares) + $100
Although the trade is profitable this situation shows one downside to covered calls. If the trader was only long stock, their profit potential is not limited. They would have made $800 if they just had long stock.
Profit – Stock Price goes up, but stays below Strike Price
Market hasn’t done much and your stock drifts to the upside and is now trading at $21.
In this scenario the call is going to expire worthless if the stock price does not pass the strike price. The profit is a combination of stock appreciation (paper profits) along with the sale of the call. This is kind of the win-win situation if you wanted to keep owning the stock for the long term. You basically just generated additional income on the side.
Profit = ((Current Stock Price – Purchased Stock Price) X Number of Shares) + Call Premium.
$200 = (($21-$20) x 100 shares) + $100
The upside to selling covered calls is the seller doesn’t have to give up their stock position, if the stock price doesn’t go above the strike price. Therefore, they could put on the same trade after the call option expires or is bought back.
By initiating this trade, the seller of the covered call is $100 off better.
Loss – Stock Price goes down from original purchase
The company has a bad earning report and the stock goes to $18.
Once again, the call is going to expire worthless. Another risk of covered calls is that the stock price has gone down to the point it outweighs the amount collected for selling the call. The loss starts once the stock price falls below the purchase price minus the premium collected.
Loss = ((Current Stock Price – Purchased Stock Price) X Number of Shares) + Call Premium.
-$100 = (($18-$20) x 100 shares) + $100
The good thing that comes out of this is that if you wanted to own the shares anyway for the long term, you still have the shares and you can use the $100 you have from selling the call to either buy more shares and lower your cost basis or you can just keep the cash to the side.
Max Loss – Stock Price plummets to $0
Uh oh, the company turns out to be completely fraudulent. Enron 2.0 and the stock goes to $0.
The worst possible situation for a covered call trade is if the stock goes to $0. Of course, this doesn’t happen often (99.9% of the time 😊), but there is still the possibility. With this situation, the trader keeps the premium from selling the call and loses the principal on buying the stock.
Max Loss = (($0 – Purchased Stock Price) X Number of Shares) + Call Premium.
-$1900 = (($0-$20) x 100 shares) + $100
Hey, look on the bright side at least you have $100 in cash instead of $0!
You don’t have to hold on to the trade till expiration
In all the above situations we talked about holding on till the expiration of the call option. You don’t have to do that in the real world. You can buy back the option earlier for a profit or loss if you want. That can be 10 minutes into the trade or 15 days.
Understanding Implied Volatility and the Greeks
When we sell an option, we get paid the premium. That premium is affected by the moneyness (in the money or out of the money) also known as intrinsic value and the time value of the option which is can be known as extrinsic value. Implied volatility is the expectation of the movement in the stock price over the period till expiration of the option. The higher the number means the less uncertainty is and the expected move is higher.
Since we are selling an option that is why we want to sell the call in higher implied volatility environments as we will collect more money.
We can make money through the contraction of this implied volatility. Of course, it can go the other way while we hold it too and premium can get more expensive or expand, but that loss is temporary if the option remains OTM as theta (time value) will decay.
The theta number can tell you the theoretical amount of money you are making each day from the option losing value due to the passage of time. This time decay of the option accelerates as it remains OTM and approaches expiration.
When to use a Covered Call Strategy?
I don’t think this strategy is one where you just do it no matter what and beat the market automatically. You’ll lose the potential on great growth stocks and get burned on stocks that keep going down. The sweet spot is on stocks that are drifting sideways or slightly to the upside.
Trade Criteria
At Mainstreetwolf, we recommend using this strategy with a stock you own but down mind selling. Meaning, you need to be detached from the stock if it gets called away otherwise you are better off just holding the stock.
I want a stock that has at least over 30 Implied Volatility Rank (IVR) and is a mid to large cap stock with a lower stock price. I don’t like selling calls on growth stocks as I don’t like capping the growth potential. I am looking for slower growing companies that have overextended to the upside on the short term (RSI (14) over 70).
The trader should have a short to intermediate bullish thesis. We look to sell a 30 delta OTM call against a long stock position that has around 30-45 DTE and close at 50% profit and re-evaluate if the opportunity still stands. Our goal with covered calls is usually to keep the stock yet still make money on the call. If the stock continues higher and we need to close the trade and get rid of the stock, we are alright with taking the profits from the shares and the call.
If you want to follow Mainstreetwolf’s real-time trades click the link: https://www.patreon.com/join/mainstreetwolf/checkout?rid=6794640
