Three Rules of Selling Covered Calls
A few weeks ago, I introduced you to an options strategy called covered calls.
It all started when Richard submitted an Ask Me Anything question, wondering what trading strategy he could use if he already owned stock in the underlying asset.
Since then, I’ve received even more questions. Here’s one from Ritchie:
Clearly, people want to know how to use covered calls. And I’m here to tell you exactly what you want to know so that you can succeed in taking financial power into your own hands.
First off, to answer Ritchie’s question, a long call and a covered call are very different strategies.
You buy a long call. You write, short, or sell a covered call – it all means the same thing. You can also buy a long call on pretty much any stock, while you can only sell a covered call on a stock you already own. Otherwise, the call wouldn’t be covered – it’d be naked.
Remember – a call option is a contract that gives the buyer the right, but not the obligation, to buy a stock at a set price (the strike) by a set date (expiration). But when you’re selling a call, you aren’t the buyer – you’re the seller. And you could end up having to sell your shares to the call buyer.
When we trade call options here in Profit Takeover, we don’t exercise the right to buy the shares. But some call buyers do. If you sell a covered call, and the buyer decides he or she wants to exercise that call option, then you’re “covered” – because you already own the stock, so you can deliver them those shares.
That said, you need to own an equivalent amount of the underlying to be “covered.” So, if you sell one call, then you need to own 100 shares of the underlying stock – because, remember, one call option is equal to control over 100 shares of stock. If you sell two calls, then you need to own 200 shares – and so on and so forth.
Now, why would you want to sell covered calls against your stock position?
Many times, investors buy stock to hold for the long-term. But if they expect some short-term turbulence, instead of dumping the stock position outright, they can hedge their position – and boost their income – by selling covered calls.
How? By collecting the option premium.
It sounds simple – and it is. But it can also be dangerous. You only want to sell covered calls on a stock if you’re okay with unloading your shares at the strike price. If you’re incredibly bullish or bearish, then selling covered calls isn’t a good strategy, because if the price moves way above the option’s strike price, then you’re forfeiting gains on your stock.
Here’s an example – say you bought 100 shares of XYZ stock for $20 a pop. You think over the next few years or so, the stock is going to move up. But for now, you expect it to stay pretty stagnant, not moving above $22.
So, you decide to hedge your position by selling a $22-strike call with one month to expiration, for about $1.00 – or $100 for one contract.
As long as XYZ doesn’t move above $22, you can collect that $100 in premium as extra income, in addition to whatever you make on your stock position. Do that for a few months in a row, and you’re taking in extra hundreds of dollars on the ‘reg.
But here’s the catch – if XYZ stock is above the strike price of $22 before options expiration, then that call option could be exercised – meaning you have to sell off your 100 shares for $22 each, losing the profits from your stock position.
In the most ideal situation, the stock will rise to exactly the strike price of $22. Then, the call won’t be in the money (ITM), meaning you get to keep your shares and the profits from that $2 increase plus the premium you collected from the covered call. In that scenario, you’d make a $300 profit from the move to $22 from $20 ($2 uptick X 100 shares + $100 premium).
All in all, covered calls are a great, relatively low-risk way to generate extra income on your stock positions. When I use them, I just have three rules:
- If I sell a call and my stock gets called away, I want to make sure I’m still making money. You need to look at the option premium and the strike price to calculate this percentage. For a 30-day covered call, you want your yield to be in the 5-10% range.
- When the call that I sold gets below $0.10, I buy it back. This way, I won’t have to sell my stock position because the buyer can’t exercise the call.
- I won’t sell a call whose premium is less than $0.50. You want to make sure you’re making enough money to make the trade worth it!
There you have it – my three rules to writing covered calls. And just like that, you’re armed with another trading strategy that used to be reserved for the Wall Street pros…
But that is now available to regular traders like you – giving you the money-making power that you deserve.
Today’s Impact Money Trade
Yesterday, we added a new position to the Profit Takeover portfolio: the Ford Motor Co. (NYSE:F) August 20, 2021 $16 calls.
And it seems that we aren’t the only ones betting on this automaker moving up.
There’s big money flowing into F – and no, I’m not talking about the 20,000-plus contracts I mentioned yesterday.
More big players are pouring in money. The biggest equity trade today is more than 14K $15.50 calls…
Expiring this Friday:
Click To Enlarge
F data courtesy of Trade-Alert
Big money like this is great for our trade – remember two-factor authentication?
We already knew that retail traders were interested in this name. And now, we’ve got impact money locking it in, authenticating our trade.
This impact money trade only has two days until expiration. We, however, have all summer – our trade doesn’t expire until the end of August.
In the meantime, track our F call – and the rest of our trades – right here.
- Clover Health Investments Corp. (Nasdaq:CLOV)
The newest member of the meme crowd, healthcare insurance seller CLOV went public via a SPAC nearly eight months ago. In that time, it’s traded between $7 and $16 – until the past week, that is. Since Friday, the stock has catapulted 185% to trade over $25 at today’s open thanks to social media attention.
- Wendys Co. (Nasdaq:WEN)
Another meme stock, fast-food company WEN has been having a great week, up over 31% in two days after yesterday’s close. WEN doesn’t appear to be the next AMC, though. On this morning’s open, shares sharply fell over 6%.
- Lordstown Motors Corp. (Nasdaq:RIDE)
This electric automaker dropped some bad news last night in an SEC filing. The company just went public and already may not be able to survive the next 12 months if it doesn’t raise more capital. The news firmly puts RIDE’s debut electric truck behind Ford’s F150, sinking shares 16% yesterday and further today – cementing our newest Profit Takeover trade on the path to asymmetric returns.
- CSX Corp. (Nasdaq:CSX)
CSX, a holding company focused mainly on rail transportation and real estate, announced a 3-for-1 stock split yesterday. That means for every single share, investors will receive two more. If you remember, UVXY’s reverse stock split was bearish for the ETF – that’s why we bought a put on the move, which is already up about 34%. But in the case of CSX, this stock split should be bullish – I’d suggest going long on this name for the next week.
VIX Traffic Light
As the S&P continues to rise, volatility should continue its drop lower. And as we head deeper into the summer months, I expect that to continue.
The VIX dropped to its lowest level since the pandemic began last week, and I still see it dropping even further…
All the way below 15 by the Fourth of July.
I’m keeping a close eye on this indicator, so you’ll be the first to know the second my traffic light changes color.
For now, we’re holding tight at a red light.
And that wraps up today, folks. Be sure to check back tomorrow for your next Profit Takeover issue – where you’ll get my true and unedited take on how to make money in the market.
One response to “Three Rules of Selling Covered Calls”
June 09 2021