Covered calls are a fairly straightforward strategy that can help the novice options trader take the first plunge and help keep a seasoned options trader’s day-to-day game sharp.
For the sake of simplicity, the examples below do not take transaction costs (commissions and other fees) into account. Transaction costs are important factors and should be considered when evaluating any options trade as they can have a significant impact on potential returns.
It’s a lesson best taught with a stock that many TD Ameritrade clients hold and trade. I also want to talk about a stock that is not overly volatile at the moment of this writing. One stock that meets this criteria: Twitter (TWTR). That all said, this is not a recommendation. It’s simply a stock that’s a good fit for our education purposes. Many of you may look at TWTR and say, hold on sir, this is a very volatile stock. I have stats that say different. If you look at Today’s Option Statistics on the thinkorswim® platform from the morning of Monday, January 26, you will see that TWTR is at its 58% percentile (middle of range) in implied volatility (IV) and only 28% for historical volatility (HV)—again not overly volatile (see figure 1, below.)
Today’s Option Statistics on the thinkorswim® platform from the morning of Monday, January 26. For illustrative purposes only. Past performance does not guarantee future results.
With the preliminaries out of the way, let’s get down to the fun. The number one thing to keep in mind: a covered call trade is a neutral-to-bullish strategy. In this case, you are long the stock so you would like it to go higher. Because you’re writing (selling) a call, you’ll likely still keep the premium you received if the stock moves sideways, but overall, higher is better. Some traders will tell you there is downside protection built in because of the call premium. This is true to a very limited extent and downside protection is certainly not a primary reason to trade a covered call. It’s helpful to teach this trade in two phases: buying stock and then selling a call. But keep in mind it’s doable to place as one trade.
Let’s assume you’ll purchase TWTR at $39.90 because you expect the stock to go higher. But what if the stock stays here or creeps up slowly? How can I add some potential return in this situation? This is nice criteria for the covered call. I like to sell out of the money calls when selling a covered call. This allows me some upside for the stock before the purchaser of the call becomes more likely to exercise his/her right the right to call the stock away from me. It also gives me a higher probability of keeping the stock should the price remain unchanged. Selling an in the money or even at the money call will increase the probability of the stock being called away prior to or at expiration (short options can be assigned at any time up to expiration regardless of the in-the-money amount). In this situation, the first question I ask before selling a call is, Am I comfortable with the stock being called away at the strike price of the call I’m selling?
In this example (figure 2, below), let’s theoretically say I will sell the March 45 call. If I sell the March 45 call, I am very comfortable with the thought of selling the stock at $45 over the next 53 days considering that the stock is currently trading for a price of $39.90.
Keep in mind a few things about this trade. First, if the stock price stays below $45 all the way to expiration day then you keep the $1.55 you sold the call for, and good for you. If the stock price rises above $45 at any time prior to or at expiration, the stock can be called away, in a normal situation the further from expiration day the less the probability of this event. On expiration day, unless otherwise directed, an option that is in the money will be automatically assigned and the stock will be called away.
The thinkorswim® platform from the morning of Monday, January 26, showing potential options calls on TWTR. For illustrative purposes only. Past performance does not guarantee future results.
If the stock is called away at $45, your net price is the $45 plus the $1.55 you sold the stock for, meaning a net of $46.55. Let’s be fair, if the stock rallies above $45, you will most likely have the stock called away and if the stock is above $46.55, then you will not enjoy any of the move above that level. That said, as we look at this, the net price (strike price + premium) received is more than 20% higher than current stock price.
Another thing to keep in mind is that options are nothing more than probabilities. On our platform, we have created the probability of expiring. As discussed with options being a probability, this feature allows you to see, given all that is known about the stock price, volatility, days to expiration etc…..at that moment, the theoretical probability of the option having any ($.01) or more intrinsic value on expiration day. The March 45 call has a 24.86% probability of being in the money on expiration day. Rounding up, that means there is a 25% probability at the time of this example (remember, probabilities can change as the stock, volatility and time move). That means there is a 75% chance that you keep your $1.55. It can add up.
Now, in fairness, you can be assigned early on this trade. You would have to sell the stock at $45, with the same effective price of $46.55. Yes, the $1.55 you receive upfront lowers your break- even price on your stock to $38.35, but if you are thinking about covered calls as a protection method, I believe you are looking at them with the wrong focus. A better focus? Covered calls to lower your basis.
By selling out of the money options, you allow for the stock to run up a bit and can make it a high-probability event that you keep the premium. There are two primary concerns: one, you limit the upside potential of the underlying stock above the strike you sell; two, that the stock goes down (in this case, down below the stock price – premium received). But more good news: this strategy has return-enhancement potential that does not take any extra margin. You can start small and then apply it on a bigger scale once you truly understand it.
Even if you never use another options strategy, this one’s an important tool to consider having in your back pocket.
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