You won’t get rich over night writing covered calls, but you can generate some strong & steady income! Let’s discuss writing covered call options!
** I know there is a disclaimer in the footer of my site and an annoying bar at the top, but I would like to reiterate that this is not investment advice. This is purely for educational purposes. Please do your own research and seek professional guidance if needed**
I intend to simplify things here. Big time. My goal is not to have you up and slinging options left and right after reading this. My goal is that you will understand what writing covered calls is all about as an investing strategy, and how they work!
Options are just for traders on Wall Street, right?
No way! While it is true that options, generally speaking, are significantly more risky than standard buying and selling of stock – they don’t have to be.
You might hear of things like straddles, spreads, and iron condors and just automatically assume that options are simply out of your league. Give yourself more credit! Further on I will break down an example of a transaction and this will all (hopefully) make sense! There are a few key things here (again, somewhat over simplified) that you need to understand to grasp the concept of most options strategies:
Premiums: The cost to acquire an option.
Contracts: Basically the quantity of options. One covered call contract, for example, is just one option. These always come in units of 100 shares of the underlying stock. 1 contract = 100 shares in some way, shape, or form. **Note, most brokerages still charge commissions to trade options. Mine charges $0.65 per contract (not multiplied by 100, just straight up $0.65)**
Call Option: The right, but not the obligation, to buy 100 shares of a given stock at a pre-specified price (strike price). These always have an expiration date. You can even say that buying a call is the same as buying ~ the option ~ to buy 100 shares of a stock (at a specified price, by or before a specified date).
Covered: This just means that you own 100 shares (or more) of the underlying stock. We’ll get more into why this matters later.
Strike Price: This is the price of the underlying stock that the option will be executed at.
Friday: Best day of the working week, also options always expire on Fridays. Some actively traded stocks have enough demand where they have options that expire every single week. Less frequently traded stocks might just have monthly options.
Below is an example of an options chain for the ETF $VOO (yes, you can trade options on ETF’s). The nearest expiration date is next month, and the holding closed at $409.93 last Friday. If I wrote a Nov 19 covered call right now at a strike price of $425, I would collect a $75 premium. I may write an article on this some time, but the Bid is the highest price one is willing to buy at and the Ask is the lowest price one is willing to sell at.
Okay. Hopefully everything above will be helpful to refer back to when we get into the nitty-gritty here. One more thing to cover, without going into the names of the Greek symbols that represent each thing (that is beyond the scope of this article, but it is important), you should understand that the value of an option’s premium is impacted by:
A change in the time left until expiration
A change in the price of the underlying
A change in the metric above (its like the movie Inception, again it gets complicated but I’m not here to teach options valuation models)
A change in volatility
Cut to the chase, explain writing covered calls to me like I am 5 years old
You got it. Let’s go.
What do you need to write a covered call? Simply a brokerage account and 100 shares of a stock. Let’s work through a scenario.
Let’s say I want to make some money. Let’s also say that I just bought 100 shares of stock XYZ for $100 / share.
Stock XYZ is currently trading at $100 / share. So, I own $10,000 worth of XYZ stock.
I, RCG, am going to write one covered call on my XYZ stock.
Through the magic of the stock market, there will be someone out there on the other side of the trade who wants to buy a call option, we’ll call them Person 2.
The market will establish the premium that Person 2 will pay me based on a few factors, we went over that above.
In this example, we’ll say the premium for a $110 strike price call that expires this coming Friday is $1.
Remember, an options contract always works in multiples of 100, so this 1 contract covers the 100 shares that I have.
When my trade to write one call option is executed, Person 2 will pay me $100 ($1 premium multiplied by the 100 shares). No matter what happens, I get to keep that $100.
Person 2 now has the right (the option) to buy my 100 shares of stock XYZ at $110 / share no matter what the price of XYZ is. They have this right up until Friday when the market closes.
So what next?
There are basically two things that can happen, the option expires worthless, or it is executed. While you can execute an option early, it generally is not the easiest thing to do and you’re probably better off trading away the premium (more on that below).
If, this coming Friday, stock XYZ is right where it was to start ($100 / share) the option will just expire worthless. I keep my $100, Person 2 gets nothing, I keep my 100 shares of stock XYZ.
If, this coming Friday, stock XYZ is sitting at a nice $120 / share, the option will be executed. I keep my $100 premium I was paid, Person 2 buys my 100 shares of XYZ at $110 / share, and that is that.
So you win either way…?
Not exactly. While it is true here that I won no matter what, there are two main risks to consider with this strategy.
In the first scenario, yes I made $100 from the premium. If, however, stock XYZ plummeted to 0 and declared bankruptcy, I would lose my $10,000 initial investment. This is the same risk you take buying any stock.
In the second scenario, I collected my $100 AND I sold my 100 shares at a gain of $10 / share. $1,100 profit. What is the downside there??
Well… had I not written a call option and just held on to my 100 shares, I could have sold at $120 and had a $2,000 profit.
So when does this strategy make sense?
In my opinion, there are two situations where writing covered calls make the most sense.
One, if you have done your research and believe that a stock is going to stay flat (not go up or down a ton) between now and the expiration date.
Two, if you need the income.
Earlier I hinted at this, something cool about options is that you are not 100% locked in to your trade.
To start, I had collected a $100 premium. What if, on Monday, stock XYZ absolutely tanks. Down to $80 / share. The premium would go down very low, let’s say it goes down to $0.20 for an even number. Instead of holding on to the written covered call, I can actually place a, “buy to close” order where I pay someone else $20 to take this written covered call off of my hands. I got a $100 premium to start, then I spent $20 to get someone else to take over the written covered call. I now am completely out of the trade, and get to keep my $80!
Why might I want to do this? If stock XYZ did tank on Monday, but I did some research and feel very optimistic that it will come back to a much higher price later on, I might be better off just holding my 100 shares and getting rid of the written covered call.
Whew. That was a lot.
Feel like I didn’t clear things up for you? My apologies!
As always, thank you so much for taking the time to read this. It means a ton to me!
If you ever have any questions, suggestions, comments, or whatever, please don’t hesitate to reach out!