Options Trading for Beginners Guide – Covered Calls and Puts
The stock market has been described as an emotional rollercoaster and over the last number of years we I can bear witness to that (no pun intended).
As we know, the stock market trades on fear and greed i.e. emotions.
You can have euphoric times, “wow, I feel great about this investing lark!”, and panic times, “this investing lark is not for me”, depending on where you are in the cycle. Sometimes you feel as if you are constantly at the mercy of the markets.
In this blog I’m going to show you one of the best kept secrets in the stock market . Its the idea of ‘renting out’ shares you own to get an annual ‘rent ‘ of about 20% or more in profit ON TOP of your share increase and the dividends you get paid too. This rent is collected using a thing called the Options Market.
The stock market trades on the fear and emotion of the investors relevant to the news and sentiment of the market. This news can be company specific or worldwide macro news. There is an old saying “if Europe sneezes, the USA catches the flu”.
However, once you understand the markets you can take this fear and emotion out of your trading. Better still I’m going to show you one of the best kept secrets in stock market investing
Ways to make money in the Stock Market
There are many ways to make money trading and investing in the stock market. See below for a summary of the main techniques I use to generate income from the stock market:
- Buy & Hold
- Buy Low And Sell High – Rolling Stock
- Buy Dividend Paying Stocks
- Buy & Rent – Covered Calls
Note: I am not introducing you to the concept of making money by shorting stocks. This involves selling stocks when they are high priced and buying them back to close out the position when they fall in price. This strategy is only for experienced traders.
Buy & Hold Investing in Stocks and Shares
When we look closely at this Buy, Sell and Hold principle we can see that, like a rollercoaster, the cycle goes up and down over time. As a result of this cycle approximately 50% of the time your shares are higher than the price you paid for them and 50% of the time your shares are lower than the price you paid for them.
While this strategy works on the whole over long periods of time i.e. decades, the value of the holding can be extremely volatile. This will not suit most individuals. The typical investor has inadequate control over their emotions. When the markets suffer pullbacks they tend to sell near the bottom rather than buying. Hence they often dispense with their Buy & Hold strategy at precisely the most financially damaging time.
If an investor can stick to the plan and weather the short term storms they should see the value of their investments rise over the long run assuming of course they have selected top quality companies for their portfolio (see Module on Fundamental Analysis).
Buy & Hold should not become Buy & Forget or Buy & Hope. These are not valid investment strategies. Why not forget about what we bought? There will be times when the market is in a bull market with prices rising high. Often these times will result in even good quality companies becoming overvalued in the short term. Hence it is wise to trim positions and lock in some profits on occasion. The stock can be repurchased on pullbacks to lower prices in the future.
Buy & Hope refers to a common strategy whereby people buy shares without any thorough research. Newspaper tips or recommendations from friends are the popular source of information for these investors. I do not recommend this approach. I advise you do your own research in addition to my blogs.
How to Buy Low And Sell High in Investing – Rolling Stock
What do we mean by the term “rolling stock”?
Rolling stocks are stocks that move between identifiable highs and lows in share price terms. They trade within a range. Stocks that are trading in upward or downward trend channels can still be Rolling Stocks (see my blog on Technical Analysis and Charts)
Finding a nice rolling stock is a great way of collecting some income, whether it is short term, intermediate term or long term. If we can find a stock that moves between a support and a resistance level on a constant basis, basically within a boxed area this can give us a fantastic return by buying at a support and selling at a resistance. And because we’re finding these levels where the share has come down and bounces off support levels at a regular basis and goes up to this resistance level and comes back down again that means we can buy at support and sell at resistance, buy at support and sell at resistance and each time we can lock in the profits.
Once we get into the habit of looking for these stocks we can spot them more regularly in relation to our box trading and then we have various different strategies that we can play if the share goes above or below the support or resistance levels. The most important rule for playing rolling stock is that you have the patience and the discipline to wait until it hits the support or resistance levels.
Once the share hits that support level you have the confidence to step out and make that play once you get your confirmation or your next day candle ( I cover this in my technical analysis blog) then you can then ride that rally up to the resistance level and then you can then sell that share and then you can collect that premium and it gets you back to cash.
It is important to be happy to own the share for a five to ten year period, have the homework done on the share and again that you have got to know the “Heartbeat“ of the company and that you have your Plan B established before opening a position.
When the price of a share comes down, a lot of investors have the fear that it is going to fall a lot further, and even though they have all the prior research work done on the company they don’t take action to make the investment or buy the share when the time is right. Often then when the share bounces up they start chasing it or buying the same share at much higher prices. The market will be there tomorrow and next week and next year, don’t chase it, have the patience and discipline to wait until it comes to you.
It is important to have five or six companies on your watch list that you can get to know. It would be highly unusual that all these companies would be at a suitable buy price at the same time. Having a stock watch list gives you more choice and opportunity to make money.
Figure 1. TSM Rolling Stock Chart in 2009 and 2010. We can see the roll in this share price between $9.50 and $11 from April 2009 up to November 2010.
We can see in the chart above (Fig. 1) a nice example of TSM rolling between about $9.50 and $11.00 dollars over a period of time from May 2009 up as far as November 2010. So within that period of about 18 months we can see it has rolled five times with $1.50 per roll that equals $7.50 profit into our hands on a share that only cost you $9.50.
Buying Low and Selling High with a stock using Support and Resistance Levels
By buying the share each time it comes down to $9.50 and selling the share each time it hits $11 we make $1.50 of profit on that trade. If the share TSM does that same roll (where we can buy it at $9.50 and sell it at $11) five different times in 18 months then we can collect $1.50 in profit five different times during that 18 months. That gives us a profit of $1.50 x 5 =$7.50. Remember the first time we bought the shares they were $9.50 and now we have already made $7.50 in profit on those five trades. That basically is what we talk about when we say that we are attempting to get a share cost basis back to free over a five to ten year period.
You can see that you nearly have the total cost of the share back in your hands within a very short period of time. It’s nice to have the option of trading some rolling stock for short term gains as the market plays within this boxed area and if we keep an eye on all charts we can see that rolling stocks become very visible as our experience in the market grows.
Remember before we take a position in the market we always have a Plan B (backup plan). So if the share does not do what we expect it to do (PLAN A) which is for the share price to roll from $9.50 up to $11 we can go to our PLAN B and collect some premium by selling a covered call on that share (see section below – Covered Calls).
Plan the Trade and Trade the Plan
These are the things that when we’re talking about technical analysis that we have the confidence to trade what we see. Once we have our Plan B. We have the confidence to trade the charts because we also have to have our PLAN B, remember PLAN THE TRADE, TRADE THE PLAN. As a rule of thumb most of the time a stock trades sideways, approximately 10% of the time it trades in an upward direction and 10% of the time it trades in a downward direction. This is where the rolls come into play. We buy the share at support and we sell at resistance. We can also collect rent at resistance by selling the call option (see section below – Covered Calls).
Let’s say for example we buy the share ABC. If the share goes up in price we can either sell the share (Plan A) or we can collect a premium by selling a covered call option at the resistance level (Plan B). Covered calls are covered in detail later in this module. An alternative Plan B might simply be to sell your share if the rolling pattern is broken or the price pattern does not follow that expected in Plan A.
Rolls can be short term which would be weekly rolls, intermediate term rolls which can take months to come back down again, and long term rolls that can take years. These are the things that we’re keeping an eye on in relation to our charting because when we’re looking at our original charts the first thing we do once we’ve found a quality company and we’ve found the heartbeat of that company we need to get to know that company inside out.
Lower Time Frames help confirm Support and Resistance Levels
Look at the chart for the ABC share on a longer term basis and you will find the support and resistance levels on that chart. Then move to a shorter chart time frame to check where the share has been over the last three, six months, one year and five years. When we have done that we can identify our support and resistance levels. This gives us a better insight into the current share price trend.
Moving onto the CSCO chart (Fig 2) we see that from 2010 all the way to mid 2011 we can see that downtrend and the down trending rolls where we had support levels that the share came down bounced and rallied back up again to the resistance level. Even though the share was in a downtrend you can still see the support and resistance levels that that share could have been traded on buying at support and selling a covered call or selling the share at resistance and locking in some profits.
Figure 2. Down-trending chart on CSCO, rolling between a support (lower line) & a resistance (higher) line. We can see the support at points B, D, F & H and we can see the resistance at points A, C, E & G.
The rolls are visible above as the price moves from A down to B and bounces back up to C. Then it rolls down again to support at point D before moving back up to resistance at point E etc,etc.
Buy Dividend Paying Stocks
A common investment strategy to earn an income from stocks is to purchase stocks which pay regular dividends.
You wouldnt buy a business that makes no profits so why would you buy a stock that doesnt pay dividends?
A dividend is a payment made by a corporation to its shareholders. If we have bought shares in the company we are shareholders. These payouts are generally made in cash (called “cash dividends”). This is a primary income stream for most stock investors.
Cash dividends are normally paid to shareholders each quarter i.e. four times per year. However, some companies pay dividends annually (once per year) or semi-annually (twice per year). Each company sets its own payout schedule and determines the dividend dates on which the dividends will be made. Some companies will even pay a special (one-time) dividend every so often. These special payouts are separate from the company’s regular payout schedule and are not factored into the stock’s dividend yield.
Not every company pays dividends, and companies can change their dividend policies at any time. As investors become increasingly hungry for yield, however, more and more companies are initiating new dividends and raising their existing dividends.
Companies have been paying dividends to shareholders for over 400 years. The first company to ever pay a dividend was the Dutch East India Company in the early 1600s.
Dividends alone have accounted for over 40% of the S&P 500’s total returns since 1929!!
Hence most of the shares in my portfolio tend to be dividend paying stocks. However, dividends represent only one of the income streams we generate from these stocks. In the next section you will learn about the powerful additional income stream you can generate from both dividend paying and non dividend paying stocks.
See the chart below which indicates the annual performance of different categories of shares depending on their dividend behaviour.
Give yourself a head start by selecting top quality dividend paying stocks. Our Alpha model will confirm which are top quality.
From the early days of stock markets through the mid-20th century, dividends were the primary method of returning value to shareholders. Price appreciation was considered more of a bonus, as people bought stocks mainly because of their sizable dividends.
Why do Companies pay dividends?
Companies sell stock shares to the public to raise money, which they then use to fund existing operations and expand their businesses. Essentially a dividend is a reward given to shareholders for owning stock in the corporation. Hence, dividends are a key way for companies to attract investors to buy their stock.
What is Dividend Yield in Investing ?
The annual dividend divided by the price you bought your shares is referred to as your dividend yield. It can vary on top quality stocks usually from 1% to 5% return per annum.
There is a wealth of information and detail which can be studied in relation to Dividend Investing. For now all we need to know is it is a good start to select regular consistent dividend paying stocks.
I also use options to turbo charge the income I can generate from my stocks.
Covered Calls -how to collect a monthly income from the stock market.
My blog on Fundamental analysis shows you how to identify a good quality company. Now I would like to show you what you can do with the shares of a good quality company once you own them in order to generate an income stream in addition to any dividends which may be payable.
One of the rules for investing is that the companies you are dealing with are ‘optionable’ companies i.e. companies for which options are traded on the open market. Not all stocks listed on exchanges are ‘optionable’. Generally stocks that trade under $5 are not optionable but there are a few exceptions.
The technical term for what we are going to teach you is ‘Option Premium’, but we like to refer to it as ‘Rent’ or a monthly premium.
This concept of collecting monthly income from options is similar to the rationale for property investment. The primary aim of property investment is to generate regular rental income streams. However, this can be achieved much easier through stock market investments in good quality optionable stocks.
Writing a covered call means you’re selling someone else the right to purchase a stock that you already own, at a specific price, within a specified time frame. Because one option contract usually represents 100 shares, to run this strategy, you must own at least 100 shares for every call contract you plan to sell.
As a result of selling (“writing”) the call, you’ll pocket the premium right off the bat. The fact that you already own the stock means you’re covered if the stock price rises past the strike price and the call options are assigned. You’ll simply deliver stock you already own, reaping the additional benefit of the uptick on the stock.
Stock Market Advantages over Property Investment
- Property investments are expensive to initiate once you take into account stamp duty, legal and other professional fees. In contrast, stock market investments are very inexpensive to initiate (though there is a trade commission payable on opening and closing positions).
- Property investments are illiquid. To sell your property investment it may take months, or years in the current climate. The price you will achieve is often unclear as there is no ready market on asset prices. In contrast, stocks can be sold in a split second based on fully transparent prices – with the added advantage of convenience; all your trades can be made instantly online from the comfort of your home or on a mobile device. Try doing that with property!
- Stock investments can have their value protected using forms of option insurance. How many people would have liked to be able to insure the value of their houses before the bubble burst? We will teach you how to protect your shares from the downside later in this manual.
The number one reason most people avoid the stock market for investment purposes is due to one single emotion, namely, FEAR. You would have no fear if you knew your shares were protected from dropping in price, would you? Most people don’t know that it’s possible to do this.
Using Stock Options to Generate Income
One of the hardest concepts to get to grips with is that you can collect a monthly premium or ‘rent’ from shares you own. This is quite an amazing concept and one of which even many market participants today are unaware.
I focus on stocks which trade on the US stock market exchanges. This is due to the greater flexibility for trading options. Although European exchanges offer some limited options they tend to be much more restrictive and limited.
This is not a cause for concern as most of the large cap European companies are traded on US exchanges in any case. They do this using American Depositary Receipts (ADR’s). The underlying basis is the same in that if the price in Europe moves 1% the price of the US ADR moves 1%.
So What are Stock OPTIONS?
Definition: An option is the right, but not the obligation, to buy or sell shares at a fixed price by a certain date.
All Options have three components
- Options have an expiration date, a date when the seller no longer has any legal obligation to buy or sell the underlying asset,
- Options have a strike-price, the price at which the underlying asset might be bought or sold
- Option premium is the price of the option. The price of options changes due to various factors discussed later in this module.
When I talk about Covered Calls I am referring to Call Options, we are sellers of call options or covered calls.
There are two kinds of Options:
- Call options
- Put options
Note – I am only discussing Call Options on this blog. I will cover Put Options in other blogs, where I will also combine both Calls & Put options for various strategies.
So What are Call Options?
All Options are bought and sold in contracts. To buy or sell options you have to trade in parcels of 100 shares which represent one contract. Therefore each contract refers to 100 shares.
Owners of shares have the right to sell ‘Covered Calls’. Covered calls are options sold against the stock. They are referred to as ‘Covered’ because you own the stock and hence if you need to honour the call you have the stock in your possession already.
For example, an owner of 1,000 shares of a company called Microsoft (MSFT) could sell ten contracts or ten ‘Covered Calls’ (i.e. 10 x 100 = 1,000).
Selling a Covered Call gives the buyer of the call the right to call away (or buy) the shares at a fixed price, or ‘Strike Price’, by a fixed date that is set at the 3rd Friday of each month (called ‘Expiration Friday’). All options expire on the third Friday of every month. However, US options can be exercised or assigned any time up to the third Friday. This is a major advantage over European options.
Technically the monthly options expire on the Saturday following the third Friday. However, they stop trading on the third Friday.
If the owner has 696 shares in Microsoft they are only allowed to sell six covered calls or six contracts, round down to the nearest 100, not up. To sell 7 call options the investor would need to buy 4 more shares so that 7 covered calls could be sold against the 700 shares owned.
- Covered means that you own the shares if required to hand them over if the price is above the strike price you have agreed.
- As you have already purchased the shares you now own them outright and you can deliver them to the market upon request.
- You are not at risk if the stock moves higher, you are covered.
- Once you buy shares your shares are your property and you are covered because you own them.
- To sell covered calls on your shares you must own optionable Stock.
Selling Covered Calls is: The Best Kept Secret on the Stock Market
Why do we sell covered call options?
- The primary reason we sell covered calls is to collect a premium or rent i.e. an income stream. It generates money.
Selling covered calls can be used like a cash cow that produces regular income not available to the investor who is using the ‘buy and hold’ principle.
For many investors, the covered call is their first encounter with options. It is a popular strategy because it generates immediate cash into the account.
- Another benefit of selling covered calls is that they give a little protection in case the share price drops. Selling covered call options on shares you own is a way to reduce the cost basis or breakeven price on a share you have bought. This is explained later in this module.
- Selling covered calls is an excellent method of eliminating greed in your trading. One of the most common pitfalls of trading is the reluctance to sell stock when it rises to a certain target price.
Selling Covered Calls
It is a fantastic income generating strategy and a way of collecting an income stream from your shares investment. This concept is not available in Ireland on Irish companies and is only available for a few companies in the UK market under much more restrictive and different rules.
In the USA there are over 3,000 companies that are optionable and you can collect a monthly premium from these shares if you own the underlying stock. Knowing that a stock is optionable is very important if you plan to develop option based trading strategies.
What I am talking about is selling options to collect this monthly premium.
Now I know what you are saying- you have heard that trading Options is very risky and dangerous.
That is correct, if you do not understand what you are doing, or do not follow the rules, and just to clarify at this point and to let you know from the start I am not in general buying options at this time we are selling them.
You will learn how to use options to generate an income or a cash premium. Possibly even more importantly you will learn how to use options to protect or ‘insure’ your shares! In this module we will focus on the income generation aspect.
The New York Stock Exchange
We buy shares on the New York Stock Exchange located at 11 Wall Street, Lower Manhattan, New York City. The origin of the NYSE can be traced back to May 17 1792. The New York Stock Exchange also known as “the Big Board” provides a platform for buyers and sellers to trade shares in companies that are registered for trading. Us Brits can easily get our hands on these stocks as well.
Chicago Options Market
We sell options on our shares in the Chicago Options Market or the CBOE and we collect premium or rent from the sale of these options. The Chicago Board Options exchange (CBOE) is the largest U.S. options exchange. It was founded on April 26th 1973 and 911 contracts were traded on 16 underlying stocks that day.
In 1977 trading started in PUT options in the CBOE.
I’m sure everyone has seen the famous Eddie Murphy film Trading Places where they traded the options on orange juice. Of course trading has changed since then and we can now make investments online from the comfort of our own home in the UK.
Why do people buy options off us ?
They buy options to control stock for a small outlay of cash. For example a share buyer of CSCO would pay $19 on Aug 17th 2012. An option buyer could buy the Sept $19 call option for say $0.60.
Like share buyers they get a quick return if the stock price increases in a short time frame. However, the percentage return is much higher on the option price than the share price. If the share price increased by $1.00 from $19 to $20.00 the call option price may have increased from $0.60c to say $1.20. Hence, the call buyer makes 60c profit on his $0.60c investment (a 100% return).
On the other hand, the shareholder earned $0.60c for selling the call plus any difference between the price paid for the share originally and the strike price of $19. The $0.60c income represents a return of 3.1% on $19 cost. So although both parties to the trade actually earned a profit the % return is higher in this case for the option buyer than the option seller.
The option buyer’s strategy is higher risk in the sense that most often options bought fall in value.
Just remember Options do Expire Worthless and we sold it to them !
So the risk for the option buyer is 100% downside by the 3rd Friday of the relevant option month. In the example above if CSCO closes under $19 on the 3rd Friday in September the $19 call option would be worth zero in only a matter of weeks.
Profiting from Covered Calls with Shares
Covered calls are one of the more conservative option strategies in which you write (sell) calls against shares that you already own.
The impact of this is basically two fold.
In the first case it lowers cost basis of the share, because you have collected premium for selling the call (and that premium is yours to keep) your maximum potential loss is lowered. When you are long a stock your maximum loss is simply the amount you have invested. When you sell a covered call against that position the rent you receive lowers your maximum losses.
In the CSCO example above, say you had bought CSCO at $19 and sold the Sept $19 call for 60c. Your effective breakeven price is now only $18.40, being the $19 original buy price less the premium of $0.60.
Secondly you must also remember that when you sell a covered call you are limiting the upside potential. Writing or selling a covered call means that if the stock reaches and goes above that chosen agreed price or strike price it will almost certainly be called away from you. That is why it is crucial for you to sell a call that is far enough away from where the underlying stock is trading for it to provide enough upside potential. It is a balancing act. Each investor will determine which strike suits their own personal objectives and risk tolerance.
The closer the strike price to the price you paid for the share the higher will be the time premium. This will provide a higher initial % return and higher protection than selling a call at a higher strike. However, the higher strike price will allow you to gain from a rally in the shares.
We generally do not Buy Call Options. We Sell Call Options.
When we have identified a quality company that we have researched and we have got to know the heartbeat of it we need to have the patience to wait until its share price has reached a support level before we buy the share. I have discussed support and resistance levels at depth in my blog on Technical
Selling Covered Calls to make a Profit
If a stock like Apple (ticker AAPL) costs $450 and selling the covered call out to an expiration date of 73 days further out brings in a premium or rent of $22.50 to sell it for $450 (the $450 Strike Price), our effective cost now becomes $427.50 ($450 minus $22.50 = $427.50) and selling it for $450 is really like selling it for $472.50 ($450 plus $22.50 = $472.50) if we are called out on the 3rd Friday 73 days later at the strike price of $450.
This is not a recommendation to buy AAPL or any stocks discussed here but it is being used to illustrate the possible income and protection available from selling covered calls.
If AAPL does not rise above the $450 strike price agreed the covered call buyer will not exercise the option because he would not pay us $450 for a stock he can buy at a cheaper price on the open market. The owner of the stock holds onto both the shares and the $22.50 per contract of premium or ‘rent’ collected for selling the covered call even though it was not exercised. He collects ‘rent’ for the 73 days of just under 5%.This 5% return is calculated by using the amount of rent collected divided by the cost of the shares. ($22.50/$450 x 100 =4.9%). The rent is paid in advance in cash.
If after the agreed time of the contract (73 days) the option expires worthless and the shares have not been called away then another covered call can be sold for another expiration date to obtain more income or ‘rent’ and reduce the overall cost of the share even further. In this example and what we mentioned earlier about the rollercoaster ride of the markets AAPL could actually still end up at the original buy price of $450 a year later having been at a higher price and a lower price during that year.
Think about the covered call premiums which could have been collected throughout the year without major movement in the share by selling covered calls and collecting the premium again and again if you were not called out and the shares were not ‘taken’ from you.
So in conclusion what we are looking for is what I call a ‘£20 note machine’ , I feed it £10 notes and it spits out £20 notes. A Share that basically trades sideways for long periods of time that we can collect premium or ‘rent’ from selling covered calls regularly. We want a quality company which is both optionable and tends to stay in the same price range for a long period of time so that we can collect premium or ‘rent’ on a regular basis while the share stays in that zone.
One disadvantage of selling covered calls is that an unexpected drive upwards of the share price of the company. Take for example if AAPL came out and announced some unexpected positive news and the share price of AAPL goes straight up to $500 the next week. The sale of the $450 covered call as per the aforementioned trade and receipt of the $22.50 premium adds up to $472.50 even though the live market share price is now $500. Many investors would be kicking themselves. This is not something that happens very often although it is good to know about it anyway.
In any case, if the share was over $450 after the contracted expiration date of 73 days then you would lose the shares, be back in cash and you would still have earned your $22.50 premium or ‘rent’ that is 5% profit in 73 days (25% annualised) on that trade, a win-win scenario for both the option seller and the option buyer! And we may also earn a dividend income payment as well!
In essence selling the covered call limits your upside potential to the strike price you decide to sell at whatever that may be.
For Buy and Hold investors, selling covered calls is one of the most effective ways to hedge against any short term dips in the market while at the same time lowering the cost basis of your investment.
In the AAPL example above it lowered our cost basis from $450 down to $427.50.
Your trading plan should be to collect premium or ‘rent’ so that you can own the share effectively for free or at a zero cost net of premium by collecting premium or rent (and dividends if the stock is a dividend payer) regularly over a 5 year period.
Selling your stock via a Covered Call is a GREAT thing – You get paid TWICE
Once you have sold your option the buyer of that call option has the right to buy your stock at a certain price (the agreed Strike Price) by a certain date (the Expiration Date). If the buyer decides he wants the stock at that agreed price he will call the broker and exercise his right and force you to sell your stock to him at the strike price. You have bought the shares so you are covered in this case. No need to have any concern here since you own the stock already and are covered in case the shares are requested from you by the person to whom you sold the option.
Options can be exercised by the option buyer (remember we are sellers) any time on or before their expiration date, the third Friday of the month that you agreed. Sometimes options can be exercised before expiration Friday. Let’s say for example a company was about to pay a large dividend to those shareholders who own the stock on a given date (Record Date). Someone may exercise his right to own the stock before the ex-dividend day and take the stock from you at the agreed price.
After exercising this right he would be entitled to the dividend as the holder of the stock on that given date. This would be classed as early expiration. It means you are back in cash having realised your return earlier than expected.
Option exercise is common when implementing a covered call strategy and it is nothing to worry about because you are covered. It means you have received cash for your stock and now you can take that cash and go buy more stock from your watch list and sell more covered calls.
HOw Much Extra Income Could you Make using Covered Calls
The amount of income you’ll get from writing a covered call depends on how high you set the strike price. The higher the strike price, the less income you’ll get, but you’ll retain more potential upside and reduce the risk of having your stock called away from you due to option exercise.
Also, you generally want to write covered calls when their prices are as high as possible, and that comes when the level of volatility in the market is highest. Recently, volatility levels have pushed dramatically higher, making now a smarter time to consider covered calls than at times in the past when the market was calmer.
Looking at some of the largest non-dividend paying stocks in the market, options expiring four months from now with strike prices about 10% higher than the current market price currently will pay premiums of between 1.5% and 3% of the stock price. That might not sound like much, but if the option doesn’t get exercised, then you can then take the stock and write another covered call. Four-month expirations let you do this three times a year, and a yield of 4.5% to 9% is pretty impressive.
Now let’s look at some examples of placing Covered Call Options
It is important to remember that before we make any investment decisions we first study the fundamentals and then the technical analysis. I cover this in two other in depth blogs.
Investment Checklist BEFORE Buying a Share
- Finalise your Stock Evaluation model scores (Quality & Value for Money scores).
- Get to know the “Heartbeat” of the company (news).
- Ask yourself whether you are happy to own the company long term (5 years or more).
- Identify an entry Point using Technical Analysis or Charting.
- Check your Indicators, Support, Resistance, MACD, Stochastics, RSI and Candlestick patterns (see section on Technical Analysis).
I ask four very important questions:
- Are we at or near a Support or Resistance Level?
- Where are the stochastics? Overbought or Oversold?
- Are the MACD bars giving us Positive or Negative Bias?
- Where is the Relative Strength Index (RSI)? Overbought or Oversold?
Plan your Trade and then Trade your Plan. Make sure you have a Plan B in your Plan.
Covered Call and Dividend Income from one Stock – Live example below of how we collect two income streams.
How Do your Write a Covered Call Option ?
1. Collecting a dividend from a dividend paying stock that we bought.
2. Collecting ‘rent’ by selling Covered calls on the same stock.
This next slide is an example of a live trade on a company called Staples (SPLS) where I bought 500 shares on the 1st June 2012 at $12.76. Our total outlay on the share was $6,380 ($12.76 x 500 shares = $6,380).
I collected regular ‘rent’ on the shares (recorded on table below) and we also received quarterly dividends (recorded on table below).
This SPLS trade is still live as I write this piece and the income I have collected is $2.57 per share or $1,285 ($2.57 x 500 shares) in ‘rent’ on my $6,380 total outlay.
That is a (ROI) return on investment of 20.1% ($1,285/$6,380 x 100 = 20.1%) in one year. Very impressive considering the share price was relatively flat for the year!
Above we can see a live example of how we have collected Two income streams from the same stock from 1st June 2012 until the third Friday in June 2013.
I purchased 500 Staples (SPLS) shares at $12.76 on the first day of June 2012. We then sold 5 covered calls on the 500 shares we owned at the $13 strike for July 2012 (for $0.42c x 500 shares) collecting $207 in ‘rent’. I was not called out of the shares in July as they were not above $13 on expiration Friday the third Friday in July (20th July 2012).
On the 26th July I sold 5 covered calls for the Sept 2012 $13 strike price for $0.29c.This generated ‘rent’ or income of $147 dollars more for me.
I also received my first dividend for owning SPLS in July of $47 (which was 500 shares multiplied by $0.11c less commission).
On the 21st Sept the third Friday in September the SPLS shares were trading at $12.36 and as the shares were below the $13 strike price the shares were not called away from me.
I then sold the 5 covered calls again for the October $13 strike price for another $0.26c and that gave us another $127 in ‘rent’ or premium.
I also collected my second dividend of $47 in October for still owing the shares.
On the third Friday in October the SPLS shares were trading at $11.23 and as they were still below the $13 strike price I did not lose the shares.
I then sold 5 covered calls for the December $13 strike price for our 500 shares collecting $0.30c per share ($0.30 x 500 = $150 less commissions =$147) which gave us another $147 of ‘rent’ for our fourth month.
I received my third dividend in January of another $47.
The share price on the third Friday in December was $11.53 and again as it was not above the agreed strike price of $13 I got to keep the shares again.
I then sold 5 more covered calls on our 500 shares out to March 2013 $13 strike price at $0.30c bringing in another $147 in ‘rent’.
Now the share price of SPLS rallied from around $11.53 up to $15.19 in February.
Coming close to the third Friday in March the share price was trading above the $13 and I knew we were going to lose the share. I noticed that we could buy back the option for March that I had sold and that I could collect a fantastic credit out to June 2013.
So I bought back the March 2013 covered call at $0.30c (only losing the commission) and giving back the $147 I had collected.
I then sold 5 contracts of the June 2013 for $0.95c. By buying back the March covered calls and then selling the June covered calls this meant I held on to the shares and therefore I was entitled to another dividend in April (dividend four) of $47.
All this income and dividend returns has added up to $2.57 per share on share that cost me $12.76 originally, thus giving me a return to date of 20.1% from June 2012 up to June 2013.My breakeven price is $10.19 ($12.76 – $2.57 = $10.19). I also still have 500 shares.
Now also remember if I am called out and lose the shares I have sold a $13 strike I will collect more premium. I will also collect the difference between the purchase price of $12.76 and the call away strike price of $13 which is another $0.24c x 500 shares which would be another $120 of income.
This extra premium I get if I am called away and lose the shares will inrease my return up to 22% on my investment from June 2012 until June 2013 on the SPLS shares that I bought. Rent and dividends of $2.57 + $0.24 call out premium= $2.81 x 500 shares = $1,405 profit on an original outlay of $6,380.
That is $1,405/$6,380 x 100 = 22% ROI.
Practical Examples of How to use Covered Calls for extra profit
Does the COvered Call Strategy Work ?
Now I will place some Sample trades and collect some premium or rent to show you how well it can work.
See also the Videos on using the Interactive Brokers platform on how to buy shares and sell covered calls on both Web Trader, and Trader Workstation (TWS) platforms.
I will now illustrate the summary screens you will encounter when you place trades on My Track platform.
Placing a Covered Call – Example 1 – CSCO – on MyTrack Platform:
- You can see below in Fig 1.1 I placed a trade to buy 1,000 CSCO at Market.
- You can see that the Bid price is $19.01 and the ask price is $19.02.
- As I placed a Market order we will get filled at the current market price which is the ask price of $19.02. This is the price that other traders who are selling are looking for us to pay for the stock. As I am willing to pay that market price I will jump the queue and get filled first.
- The order I placed is a buy order and you can see that the order is in green. Green is for BUY.
You could place a Limit order where you dictate the price you want to pay for the share and you would only get the share if it came down and hit that price, for example let’s say your limit order was for $18.50. You would only get that share if it came down to $18.50. If it did not come down to that level your order would not be filled.
Make sure you ALWAYS read your entered order before you press the confirm button. Don’t rush a trade, it is very important to Plan your trade first and then Trade your Plan. One of the most common mistakes that traders make is rushing to get a trade done or chasing a trade and maybe they buy when they meant to sell or sell when they meant to buy. Then they have to get out of that position and enter the proper trade and end up paying two sets of commissions.
Plan your trade and trade your plan. If in doubt stay out!
Fig 1.1 Placing a Buy Order on the My Track Platform
You can see below in Fig 1.2 the order was executed by the broker at market price which was $19.02 for the 1,000 shares. Complete fill of 1,000 shares at $19.02.
Fig 1.2 See My Track Confirmation of Shares Bought
Below in Fig 1.3 we can see the Options chain for CSCO for the month of October. An option chain is simply a table showing the different prices of each call and put options at each of the various strike prices for a given month.
We can see the Bid and Ask price of the options and the days to expiration of this contract. At the time the snapshot was taken the Bid (c-bid) for the October $19 Covered Calls was 72c and we can see the days to expiration (dexp) 3rd Friday are 65 days.
We can see other strike prices like the October $20 strike bid is 32c. We can also see other months where rent is also available Nov/2012, Jan/2013, Apr/2013 on CSCO at various strikes.
Fig 1.3 My Track Sample Option Chain – October 2012
Fig 1.3a Option Chain Terminology – My Track Platform
Bid Price: The price a buyer is willing to pay for the security.
Ask Price: The lowest price that the seller is willing to take for the security.
How do I Make a Trade on My Track Platform
Select My Trade in the top left hand corner of your my Track Edge page (just below ‘file’).This will bring up your my Trade trading platform.
To sell options on simply click the drop down box on your My Trade page under ‘Trade Type’ and select Option.
Below in Fig 1.4 you can see that we have placed an order to
- Sell To Open Quantity of 10 contracts of the
- CSCO October 2012 $19 strike covered call
- At a limit price of 72c (i.e. we will not get filled unless the price is available)
- For a duration of GTC Good till Cancel (which means the order will stay there for a maximum time period of 31 days or less if we decide to cancel the order).
- Then Press Send after reading your entered order to ensure it is correct
As I am selling you can see that the order is Red. Red is for SELL on My Track.
Fig 1.4 Placing an Order on My Track to Sell Call Options
How to check Open Positions of covered calls on Mytrack
To check your open positions in shares and options simply click the tab on your screen called “Positions”.
Below in Fig 1.5 we can see in our positions that we have 1,000 CSCO and we also have a second position of the CSCO OCT12 19C showing quantity of -10.
This shows us that we have sold 10 contracts of that position.
Don’t worry about the average price shown as the system takes a large commission on this simulated account.
Fig 1.5 How to check for Open Positions on My Track
Below in my transaction section you can see the trades I executed date and time and the prices I achieved.
Fig 1.6 Trade Execution Note
This system lets you place orders and sends alerts to your e-mail or phone when a price or position is triggered.
Now let’s look at what I did in the trades above.
- Buy 1,000 CSCO @ $19.02
- Investment of $19,020
- Sell the Oct $19 Call Strike @ .72c (65 days until expiration)
- 0.72 x 1000 shares = $720 rent or profit of 72c – 2c = 70c x 1,000 = $700
- $700/19,020 = 3.8% Rent for 65 days.
- If the Share is above $19 we will get called out.
- If the share price is not above $19 in 65 days then I will hold on to the shares and our net buy price or breakeven price is now $19.02 less 72c which equals to $18.30 before commissions.
So I would have brought my cost price now down to $18.30 and as we still own the shares we can sell another 10 contracts of covered calls for another expiration date and collect more premium or rent to further reduce my cost basis.
Hard to believe isn’t it, now you know why it is called “the best kept secret”.
It is important to keep a log of your trades.
Time Value v Intrinsic Value with Covered Call Options
In the example above I only treated 70c of the 72c as profit. Why?
The option price of 72c for the $19 strike call was available when I bought the shares at $19.02. That means I bought the share for $19.02 and contracted to sell the share at $19.00 which was 2c less. The 2c represents intrinsic value and the 70c represents time value. The 2c is not profit as we are agreeing to sell our shares at 2c less than I paid for the shares. See later in this blog for a more in depth explanation of intrinsic versus time value.
Fig 1.7 Income Tracker CSCO
You should have five or six trades prepared at all times in anticipation of the direction of the market going down or up. Remember you are buying for the long term and not the quick buck, what we’re trying to do is build an investment to collect the monthly premium, to have an income generating strategy going.
You prepare your trade, you’re getting in and you’re getting out.
Buy and Hold v Covered Calls: Points to remember
Most Investors have already heard of the Buy and Hold principle or “Buy and Hope” as it is sometimes referred to.
If you are in a Buy and Hold strategy you make money if the share goes up. In Buy and Hold strategy you own the stock and you hold the stock in anticipation of price appreciation. If the stock you hold pays dividends you will also collect those dividends during that time period that you are holding the stock. You make money if the shares go up.
In respect of the covered call strategy. You get some limited downside from selling a covered call on your stock in exchange for putting a lid or cap on your upside potential, and in return for that and in these times that we live in (the rollercoaster effect of the markets) that can give you that “sleep better at night factor”. You make money if the share goes up, you make money if the share stays flat and you might make money if the shares go down a little.
For an example let’s assume you have purchased a share called XYZ at $30.There is a Covered Call Option available for the $35 Strike price for the next calendar month that someone in the options market is willing to pay $2 out to the third Friday or expiration Friday of that month. Because you already own the shares that you purchased at $30 you are covered. By accepting the $2 per share “premium or rent “you agree to sell your stock at $35 any time during the agreed time frame up to the option expires on the third Friday of the agreed month.
Now let’s look at the various implications and main differences between the two strategies Buy and Hold and Selling Covered Calls.
Buy and Hold: If the stock goes up what happens?
If the stock let’s call it XYZ goes up then the buy and hold strategy makes a profit.
Covered Call: If the stock goes Up?
If the stock XYZ goes up then the covered Call strategy makes a profit. Remember you have put a lid on your profit at $37 per share, that is the agreed strike price of $35 + the $2 per share of call premium or rent you collected.
Buy and Hold: What happnes If the stock stays Flat?
If the stock stays flat then in the buy and hold strategy you break even.
Covered Call: What happens If the stock stays Flat?
If the stock stays flat then in the covered call strategy you make a profit. You make a profit of $2 per share which is the amount of premium or ‘rent’ received for selling the covered call.
Buy and Hold: What happens If stock goes down?
If the stock goes down in a buy and hold strategy you make a loss.
Covered Call: What Happens If the stock goes down?
You can make a profit and you can make a loss.
You can still make some profit if for example XYZ goes down less than the $2 per share (amount of call premium or rent received) that you received.
You will make a loss if XYZ goes down more than the $2 per share you received.
If this happens the difference between the buy and hold strategy and having sold a covered call will be that your loss will be $2 per share less having sold the covered call than if you were in the Buy and Hold strategy because you will already have collected that $2 in premium or rent giving you that limited downside protection.
In scenario 1 you have put a lid on how much upside potential you can achieve.
In both scenarios 2 and 3 above you will notice that you come out better by selling a Covered call on the stocks you hold than you do in the Buy and Hold scenario.
This upside potential limit can be raised any month by raising the strike price as far up as you want but also bear in mind that the higher you go with the Option strike price the Lower the Option Premium or ‘Rent’ that will be available for that time frame (check your option chains for examples).
If you sell the near or front month options then if you are not assigned on the stock (meaning that you do not lose the stock having sold the covered call) then you can rent again for another month. Each month you do this you collect more option premium or as we like to say you collect more Rent.
Investors get to love selling covered calls on a monthly basis because they can repeatedly sell covered calls against the same stock month after month or quarter after quarter that is as long as the stock is not called away from you it is possible to generate a monthly income stream on the same shares. Now you can see why it really is “the best kept secret”.
If the Stock is called away from you then you can buy the shares back at a support level with the cash you received and repeat the process of selling more monthly covered calls again.
You start by having a watch list, and from that watch list you’re always going to be looking for your support and resistance levels on your shares and then you have your Plan B- the “What If” scenario, what’s your plan?
Another important thing to make sure that you have for your business is that you keep a log of your trades. Remember Plan your trades, trade your plan and keep a log of your trades.
Options Trading – Covered Calls – Have your research done for potential stocks in advance
These pre-planned trades would be prepared in advance so when the market comes down and hits a support level we can actually step out and make those trades. The biggest problem traders have is that when the market comes down most people move into a FEAR mode. This Fear mode means that you think the market is going to go down even further, and as a result of that you can actually miss a good trade that you’ve been waiting on for a period of time because the market may bounce off the support level after buyers come in and make their trades.
If you’re prepared and have your trade’s ready- the old saying PLAN YOUR TRADE AND TRADE YOUR PLAN comes into play. Once the market comes down you can step out and make that play and make that investment at that time on companies you have already researched and have been on your watch list. You always have your Plan B just in case.
An example of what I mean by Plan B with covered call options trading
Your Plan A could be to buy shares at a support level and let them rise up to a resistance level, then sell a covered call.
Now let’s say the share came to a support level and you stepped out and made that investment at that stage, this is when you need your Plan B.
What if the shares go down lower? What do you do?
This is where your Plan B comes into action. If after you have purchased the shares they dip down lower you can then sell an At The Money (ATM) covered call and collect some premium or rent. The trend has changed, you would not now be waiting for it to go up to a resistance level, you would be taking action now because it broke the support level and would be heading down to the next level or a lower support level.
Once support is broken you need to take defensive action especially if you have not employed an insurance strategy.
By selling a covered call after it breaks down through your support level you would then take the premium or rent on that share by selling the covered call to protect yourself somewhat from further downside. Basically taking the rent before the fall or collecting on the fall before the next fall.
Always remember the reason you are stepping out to make a play
The share has come down to a support, you already have prepared your Stock Evaluation model, you are already happy to own the share for a five to ten year period, and it is one that you have had the patience to wait on to come down to these levels. Hence at this stage you are step out to make the play or to place the trade.
Call Prep Sheet – The key to Covered Call Success
As I mentioned earlier, you should always have a watch list and from that watch list you should be monitoring six or seven stocks at a time. Not all of these companies are going to be at a support level or buy price at the same time. You will need PATIENCE.
I have constructed a simple template below in Fig 1.8. When you enter the figures in relation to the level that the share price is at the model can actually work out what is amount of rent which you can collect if you don’t get called out of the option. The model will also calculate your return if you are actually called out.
The template can give you an idea of exactly how much rent you can collect per month, or what percentage rent return on your investment you can collect.
Fig 1.8 Covered Call Prep Sheet
Warren Buffett once said “only buy something that you would be perfectly happy to hold if the market shut down for ten years”
When we’re selling covered calls we are “Sellers of Time”, when we buy shares and sell our covered calls we are collecting the time premium. This premium melts as each day goes by. The technical term is time decay which is also known as ‘Theta’. The time value in the option premium falls or melts with each passing day.
Options premium is like an ice cube melting in the sun
The ice cube melting analogy states that an option premium is like an ice cube sitting outside on a hot day. As time passes, a little more of the ice cube melts, until there is nothing left at all, i.e. the option time premium disappears as the number of days until expiration fall all the way to zero (on the third Friday). In My Track this is expressed as “dexp” which is Days to Expiration.
See illustration below in Fig 1.8a.
Fig 1.8a Option Time Premium – Time Decay or Theta (Ice Cube Analogy)
If the share is at $16 dollars today and someone is giving you for example $1 to hold that share for them for one month or thirty one days, then if we assume the share price stays flat then as each day that goes by call buyer is not going to give you the same amount say when only twenty days time are remaining. You would not pay the same amount to rent a villa for just twenty days as you would to rent it for 31 days, would you? It is the same for options time premium.
If the share price is $16 dollars today and he is giving you $1 as premium or rent to hold that share for him for one month. In eleven days time there will be only twenty days left and assume the share price is still at $16 dollars the call buyer is not going to give you $1 in premium or rent now. He may only offer you 70c.
A certain amount of time has melted, or as we say that ice-cube has melted. The option or ice cube has melted by thirty cents in those eleven days while the stock price has stayed the same. Options melt everyday and the Greek word that is given to this element of option pricing is Theta or time decay. This is referred to as one of the Greeks. The others are Delta, Gamma, Vega and Rho. So now you can see that the premium of the covered call melts into your pocket each day.
Obviously you should now see that you need to make decisions as to when to sell your covered call. The longer you wait to sell the call option the lower the rent you will collect unless of course the share price rallies up. This is where Delta becomes relevant.
Writing covered calls is a very lucrative strategy if used properly because if you have a portfolio of good quality companies that you have bought at the right price after waiting on their price to dip and have had the patience to wait on them to come down to a level of support. You can sell covered calls and then collect that premium either instantly or once the share rises and hits a resistance level.
If you employ this strategy make sure that you are writing calls against stocks that you would hold regardless, remember what Warren Buffett said, otherwise treat the position as highly speculative and invest accordingly. We will discuss asset allocation in relation to your portfolio at a later stage. Asset allocation is very important for everyone’s portfolio.
Patience is very important when trading, it has been said that women make better traders because they follow the rules. Don’t be forced into any trade. I’ve had investors and traders come to me saying “I bought because the stock did this or it did that” when you know from looking at the support and resistance levels on the chart that if they had waited on the signal or the candlestick pattern that things would have been different.
When you see a roll pattern unfolding in a share price, maybe a share has gone from $15 dollars up to $18 dollars, some investors think this is never going to come back again and they go against their own rules and step in and buy the share, they get it into their heads that it will never come back to $15 dollars. Then if some bad news breaks in the markets or some bad news on the company from earnings is announced the share might come back down to $15 support. Now they are disappointed that they did not have the patience to wait.
Good Traders trade like a robot – They don’t trade because they are bored
Don’t be forced into a trade. Have your watch list ready for five or six companies that you have got to know the heartbeat of and have the patience to wait until the share price comes to your level.
Always remember the saying that “Good news can last three days, and bad news can last three months”. The reason bad news can last three months is that it’s going to be three months before the next earnings release date. They say good news last three days because by then traders are dealing with another macro news item. Don’t be forced into a trade- “If in doubt STAY OUT”.
Remember Cash is a Position, and Sitting on your Hands is a Strategy.
Two of the most important things you need for Selling Covered Calls are:
Make sure and check the Open Interest in the Option contract you are planning to trade.
Generally we are looking for an Open Interest of more than 100 contracts. This means that there is liquidity in the options and hence when you want to sell your calls there is someone who wants to trade with you or buy the option. If liquidity is low then you may find there is a wide spread between the offer and bid price of the option. This can make it more difficult to determine the fair price for the option.
Make sure to get to know the Heartbeat of the company. Treat this like any other business. If you were opening a shop you would make sure you had a good location. You would make sure you had a passing trade to buy your product. You would do research on location and product. You would get to know your customers, their needs and your competition. You would set up your shop lay it out well, fill the shelves, spend money on fittings and then pay staff, electricity, rates rent and other charges and you would also give it all the time it needed so that the business could became successful.
Your stock market investments should be treated with the same respect. My aim is to help provide you with the basic tools to conduct research and to understand how to trade and collect income streams from shares.
Summary for those new to Covered Call Options Trading
- Treat the stock market with respect. Plan your trade and trade your plan.
- Buy the shares at support, have the patience to wait until they hit resistance and then sell your covered call and collect that premium.
- Sell the Covered Call at Resistance.
- Always Sell the Next Month Expiry out (at least).
- Always sell the next Strike Price “Out of the Money” (unless charts indicate a defensive tactic required)
- Don’t be Greedy.
- It’s not about “timing the market it’s about time in the market”.
Strike Prices for Covered Calls can be:
- ITM (In the Money) -The Strike price is Below the Stock Price.
- ATM (At the Money)-The Strike price is Equal to the Stock Price.
- OTM (Out of the Money)-The Strike price is Above the Stock price.
Stock Price: Call Option:
$20 $19 which is ITM by $1.
$20 $20 which is ATM.
$20 $21 which is OTM by $1
Options premium are priced to include Intrinsic Value and Time Value.
Options Covered Call Traders are Sellers of Time
We are writers (or sellers) of covered calls and we love getting paid for selling time premium. We collect the premium or rent as time keeps melting or decaying each passing day like a melting ice cube.
Covered call options have been described as a wasting or a decaying asset, they are losing value each passing day. This works out in favour of those who are sellers of options.
Remember we are sellers of options and thus we are “Sellers of Time”.
We sell options when they have a time premium and then wait as that time premium melts into our pockets. On expiration the time premium is zero, it has melted away and the option has either expired worthless or if it is “In the Money” is exercised and the shares are called away from you and you have a wheel barrow load of cash.
Let’s look at a couple of examples of Covered Call Options Trading
In relation to OTM (Out of the Money) call options the time premium is the full option price available. Let’s say you bought a share ABC at $37 and sold a covered call option with a strike price of $40 (OTM) for $1.The time premium in this case is the full option price. The option has a time premium of $1 per share.
Now let’s say you bought the share ABC at $37 and sold an ITM (In the Money) option of a strike price of $35(ITM) for $5 premium. How do we work out the time premium? For ITM options the time premium is the call price + (plus) the call bid – (minus) the current stock price. That is ABC stock is sold at $35 plus the amount received for the call $5 minus the price the stock was bought at $37. That is (35+5-37 = $3).The ITM option has a time premium of $3.
The most important thing to remember here is that in both scenarios whether we sold an OTM call or an ITM call in both of the above cases the time premium is your income or ‘rent’ or profit between when you sold the covered call option and the option expiration Friday. As well as time premium you may also get capital gain if the share went up. The share may go down and you may have some capital lose but still have gained the time premium to give you some limited protection.
Some investors want to collect time premium but also leave plenty of room for upside potential or capital appreciation of the share as well. They achieve this by selling OTM (out of the Money) calls where they are selling the strike price which is higher or above the current stock price. The reason they would do this is they want to reduce the chances of the share being called away from them and still collect some Rent or time premium. Another reason is that they think the stock may rise up between now and the expiration date agreed and they want to gain from the upside movement of the share in that time period.
They are more bullish on the stock and are anticipating more upside movement and as a result of this bullishness are willing to give away some downside protection. Remember if you sell a covered call against your stock you are limiting your maximum upside potential to the value of the strike price plus the rent or time premium you have received for the option.
Intrinsic Value or Real Value is the amount if any by which an option is in the money. Time Value is whatever the premium of the option is in addition to its intrinsic Value.
E.g. 1 Take as an example CSCO where the stock price is $20. If the September $20 call Option is $1 the Intrinsic Value in this case is ZERO as the Strike price equals the Stock Price so there is no real value other than time.
The Time Value in this case is $1 which buys One Month of time out to the third Friday in September.
E.g. 2 Lets Say CSCO stock price is $20. Assume the September $18 call option is equal to $3. Now the Intrinsic Value is equal to $2 as the Strike price is $2 below the current price. So the option price must have at least $2 in its price (being the 20 less the strike price 18, $20-$18=$2). Any extra amount in the option price will be time value.
Hence, the Time Value is equal to $1 being the $3 price less the $2 of intrinsic value. This buys One month of time premium to control the share.
Remember as we mentioned before Options expire on the third Friday of the month. Options can be exercised any time up to the third Friday. It is rare however for the option buyer or seller to actually exercise the option before the third Friday.
Example: Options Trading Covered Calls on Intel (INTC)
Now as another example let’s say you have finalised your call prep worksheet and you have finished your Alpha evaluation Model on INTC. It is a company that you would like to hold long term and you would also like to collect some premium or rent from the share while you have it. You may have been watching INTC for some period of time waiting on this entry point. Let’s say it has come down to a support level at which you are happy to buy.
You proceed to place your order in to buy the shares.
Fig 1.9 Buy Shares Order on My Track
Above you can see you placed an order to buy INTC at market. The order is in Green therefore you know it is a BUY order.
Once you confirm your order you can see that it was executed and it is now in our positions (see Fig 1.10 below). You also see that you bought 1,000 shares of INTC at $26.58.
Fig 1.10 Order Execution (Filled) Note
Now what was your plan for INTC?
Were you buying at support to let the share “pop” up to a resistance level so that you could then sell your covered call? If you buy at support and have the patience to wait until the share price rises then the premium we can get for the Covered Call will also have increased. So you can wait until the share rises towards resistance and then sell the call
Or were you looking at your Covered Calls Prep Sheet (Fig 1.11) and noted if you sell the INTC October 2012 $27 call strike that you can achieve 4.25% in 65 days as shown below by collecting 71c on the shares you purchased at $26.58?
Fig 1.11 Covered Call Prep Sheet – Watch list
Remember if you sell the $27 strike price and the shares are above $27 on the third Friday of October they will be called away from you by the person you sold the covered calls to. He will pay you $27 per contract or $27,000 for your 1,000 shares and as you only paid $26.58 for the shares you will then get the extra premium of .42c per share or another $420 on top of the $710 you received into your account when you sold the covered calls.
This 42c is the difference between your buy price of $26.58 and your sell price of $27 of each share. As you have 1,000 shares this means you have 0.42 x 1,000 = $420. This means that you will get $420 +$710 = $1,130 of profit on your outlay of $26,580 in 65 days which equates to 4.25%.
If you are not called out you still get to keep the $710 of premium or rent paid to you which equates to $710 on the $26,580 invested which works out at 2.67%.Your breakeven price if you are not called out is then $25.87 as shown in the prep sheet. This figure is derived when you take your buy price of $26.58 less the $0.71 being the amount of premium or rent you received i.e. $25.87.
Plan your trade and Trade your Plan.
Fig 1.12 Selling Covered Calls on your INTC Shares
Fig 1.13 Order Executed Confirmation
As shown above we have collected our premium or rent of .71c per contract or $710 for our sale of the October $27 covered call.
Hard to believe isn’t it, now you know why it is called “the best kept secret”.
First thing you should do is to keep a log of your trades so that each month or each time you sell your covered call you can update your sheets and then you can see how much premium you have collected from each company and you can then easily see your breakeven price.
I will provide these basic trading sheets to you as part of this course. Other more advanced trading sheets are available to members of the exclusive Traders Lounge when both your trading and experience level have progressed.
Fig 1.14 Income Tracker Sheet: INTC
Again I are assuming that you have your homework done and you are happy to hold this share if need be for a 5 – 10 year period.
Example Covered Call Options Trade : DELL
If you buy 1,000 shares of a company let’s say DELL (see prep Sheet) at a cost of $12.25 per share you will have invested $12,250.
You can now SELL covered CALLS on the security because you OWN the shares.
We make money from selling the Covered Calls. Remember we are sellers of time. This is the Premium or Rent that we collect.
After buying the 1,000 shares @ $12.25 = $12,250. This represents our investment outlay.
You can now SELL the November $13 covered call Strike price for 53c for the 93 days.
This gives you an immediate return on investment (ROI) of 4.3 % profit for the 93 days.
You earn $530 (1,000 shares x $0.53c) by agreeing to sell a covered Call on your shares for a period of Time being out to November 93 days. This 4.3% premium is paid to you no matter what happens to the share price. You get to keep this premium.
If the Share price is above $13 in 93 days time you will get paid an extra $0.75c per share (the difference between the SELL price and the BUY price 13 – 12.25 =.75c) i.e. 1,000 shares x $0.75= $750
Now if the shares are called away from you at $13 you have collected $530 + $750 = $1,280. So the Return on Investment then would be $1,280 profit per $12,250 invested = 10.5% ROI in 93 days.
Hard to believe isn’t it! Now you know why it is called “the best kept secret”.
How to Close a Covered Call Position
Please note we can always close out our open call positions at any time we wish (while the market is open) by simply place an order to “Buy to Close” the calls following the steps just as we did before when we illustrated in Fig 1.4. The only difference is we select under Action the step “Buy to Close”.
After Expiration Friday – Covered Call Options Trading
A question I receive regularly after expiration weekend when some traders lose their shares is “what am I going to do now”?
I had these shares of ABC for a few months and collected premium every month for the last few months and now they have been taken off me. What am I going to do?
They get a shock when I say “that’s brilliant you are now back in cash” and you can just go and repeat the same process again, remember the watch list, you have been monitoring five or six companies. One of those companies will likely be at a support level giving you a buy signal and as you have your research homework already done you can then buy that company and repeat the process of collecting premium again.
I have a saying “it’s all about the Rent”, keep taking the RENT!!
Maintenance of your Portfolio – Covered Call Options Trading
I roll my covered call option from one month out to another. Rolling a covered call option is when you have a call option position and you buy back that option before its expiration and sell a different call option at a different expiration month or a different strike price or both further out in time. I call this exercise “account maintenance” of my portfolio.
Rolling covered call options is a very important part of maintaining your covered call positions and collecting your rent or time premium. Each month about 10 or 12 days from expiration Friday I will go through my portfolio to see what maintenance is needed for that month. I will be looking at what time premium has melted in the last month since we sold our covered calls on various shares and we will be checking to see what calls we can roll out to the next month to collect more rent and gain from the extended time premium. By that I mean I will buy back the 10 or 12 days of time of the current month and then it will be added on to the next month out and I will get more time premium or rent for the next month which is longer in time.
Remember what we are …We are sellers of time.
There are different reasons that you might want to roll forward your covered call position. Most of these reasons will be because of the time decay in the option premium that has already happened.
- No time premium left in the option as the stock may have fallen in price.
- No time premium left in the option as the stock may have risen in price.
- It is close to expiration Friday and there is little time premium left and as we are “Sellers of Time” you wish to sell more time for another month and collect more premium or rent.
As I stated earlier in this manual we are “Sellers of Time” and covered call selling or covered call writing is about collecting rent or time premium over a given period. If the covered call that you sold has little or no time premium left then you can consider buying it back and selling another month further out that has more time premium to collect and gain more credit for your account.
For example let’s consider that you bought 100 shares in a company called ABC at $30 and you sold a covered call option on a $35 strike price for $2 giving you $2 of time premium per share. Now consider that just coming up to the expiration date ABC is still trading at $30 and the option you sold has now decayed or melted in time down to be only worth .20c.Looking at the option chain you notice that there is another option available with a strike price of $35 two months further out from now and this option is trading at $2.50.This gives you the ideal opportunity of rolling your option for great time premium and a healthy credit. It will also bring down your average cost price of the stock.
You could buy back your covered call option for .20c that is closing it out before expiration thus releasing you out of the contract that you had and then selling the covered call out two months further at the $35 strike price for $2.50.By doing this trade you have received a further net credit of $2.30 of time premium or rent on top of the original $2 that you received .Now your cost price has been brought down by $4.30 ($2 -.20c + $2.50) from $30 down to a now breakeven price of $25.70.Now you know why it is the “best kept secret”.
Another thing you could do is just allow the covered call option to expire and then on the Monday after expiration Friday just sell another covered call further out and collect your rent or time premium.
Just a reminder to say that just because you have sold covered calls on any stock that you own does not mean that these stocks cannot go down or that you won’t lose money. Like any investment there are risks with covered calls as well. Remember from earlier you are putting a lid or capping your upside potential and you are giving yourself some limited protection to the downside or reducing your downside risk. If the stock falls and you have a covered call sold on it you will lose less than you would if you were in a buy and hold strategy.
The covered call strategy works best for stocks which you do not expect a lot of upside or downside movement. Shares that stay in a zone, those “Steady Eddies”. You would prefer your stock to stay consistent as you collect the ‘rent’ or time premiums and lower your average cost every month.
What Stocks Are Optionable for Covered Calls ?
Stocks below $5 are generally not optionable but there are some exceptions.
Many stocks have single $1 Strike Price intervals which is great for selling covered calls as it provides more choices and you will see some companies have $2.50 strike price intervals. Higher prices stocks can have $5 price intervals.
Always remember We are Sellers of Time
As Time goes by the Ice Cube Melts or the Option melts into your pocket.
The Option time premium melts each day. This is referred to in Greek terms as Theta or time decay. The premium for the covered call melts into our pocket.
Writing Covered Calls is a very useful and lucrative strategy if used properly. Please follow the rules.
If you do use this strategy make sure you are writing calls against stocks you would hold regardless.
Otherwise treat the position as highly speculative and invest accordingly.
How to KNOW whether a Covered Call Option price will rise or fall
DELTA – One of the Greeks
As I said earlier if the stock price goes up the option price goes up as well and if the stock price goes down the option price goes down as well.
We can calculate how much the option price will increase or decrease by using Delta.
The Delta figure is how we can tell how much an option is going to rise or fall relative to a share price going up by $1 or coming down by a $1, i.e. Delta measures the rate of change of option value in relation to changes in the stock prices up or down.
Let’s look at an example of CSCO to predict Option price
The share price is $19.02 the price we bought it at and the option price for the October 12 $19 call is 72c (See below c_bid).
And the Delta of this option is 51 (We can see that below as c_hr).
We also see the Days to Expiration of this contract is 61(dexp).
Fig 1.15 Open Interest (c-openI)
Open interest in relation to the amount of contracts that are open (c_openI). A large open interest indicates more activity and liquidity in the share the easier it will be to trade the option.
Now let’s say we buy the share at this price of $19.02 which we have checked our charts and believe this to be a support level. Now we want to let the share price rise by $1 to $20 .02 a resistance level and we would like to know how much the option would be worth at that time relative to all other things remaining equal.
If the Delta is 0.51 as seen above that means that if the share price rises by $1 then the option price will rise by 51c.
Since the Option is currently worth 71c, as seen above, a share price rise of $1 to $20.02 when the delta is 51 will mean the option will be worth 71c +51c + 122c assuming everything else being equal. We know as the days go by the options are melting (Theta). This is why we keep an eye on our positions and sometimes we need to do a little maintenance on our accounts. Remember if the share price does not go up as far as $20.02 then we will not get $1.22 for selling the option. Don’t be greedy.
Other option Greeks are Theta, Vega and Rho.
- The Option Greek called Theta measures the passage of Time. Often referred to as Time Decay. It measures how much the option price will drop as we get closer to the option expiration date.
- Vega measures the sensitivity of the share to volatility in the market. If volatility rises Vega measures how much the option price will likely change.
- Rho measures the sensitivity to interest rates.
Patience is Key to Covered Call Options Trading
Always remember the Market will be there tomorrow and next week. Don’t be forced into a trade.
Use the Quiet times to educate yourself. Simulate trade as much as possible to get familiar with trading. Fill in you prep sheets and if in doubt stay out.
News Moves the Market With Covered Call Options Trading
Remember that 80% of the Time Stocks moves sideways, 10% of the Time Stocks move Upwards and 10% of the Time Stocks move Downwards.
As I have highlighted in our technical analysis section it is important to get to know your charts, get to know support and resistance levels. This is the basis of becoming a successful trader.
In conclusion you now know how to generate a monthly income from your share investments through selling covered calls. In my other blogs you can learn how to pick top quality stocks, build a diversified portfolio and buy them at the lowest possible prices.
We shop ‘wholesale not retail’!
Finally please read below some wise words from one of the world’s most successful investors.
The key to mastering any skill is to have a specific plan — “A Road Map to Success” so to speak.
It is important to follow that map and stick with it until your objective is achieved.
Lets Recap on the idea of Covered Calls
First, choose a stock in your portfolio that has already performed well, and which you are willing to sell if the call option is assigned. Avoid choosing a stock that you’re very bullish on in the long-term. That way you won’t feel too heartbroken if you do have to part with the stock and wind up missing out on further gains.
Now pick a strike price at which you’d be comfortable selling the stock. Normally, the strike price you choose should be out-of-the-money. That’s because the goal is for the stock to rise further in price before you’ll have to part with it.
Next, pick an expiration date for the option contract. Consider 30-45 days in the future as a starting point, but use your judgment. You want to look for a date that provides an acceptable premium for selling the call option at your chosen strike price.
As a general rule of thumb, some investors think about 2% of the stock value is an acceptable premium to look for. Remember, with options, time is money. The further you go out in time, the more an option will be worth. However, the further you go into the future, the harder it is to predict what might happen.
On the other hand, beware of receiving too much time value. If the premium seems abnormally high, there’s usually a reason for it. Check for news in the marketplace that may affect the price of the stock, and remember if something seems too good to be true, it usually is.
Many investors use a covered call as a first foray into option trading. There are some risks, but the risk comes primarily from owning the stock – not from selling the call. The sale of the option only limits opportunity on the upside.
When running a covered call, you’re taking advantage of time decay on the options you sold. Every day the stock doesn’t move, the call you sold will decline in value, which benefits you as the seller. (Time decay is an important concept. So as a beginner, it’s good for you to see it in action.)
As long as the stock price doesn’t reach the strike price, your stock won’t get called away. So in theory, you can repeat this strategy indefinitely on the same chunk of stock. And with every covered call you run, you’ll become more familiar with the workings of the option market.
Options offer alternative strategies for investors to profit from trading underlying securities. There’s a variety of strategies involving different combinations of options, underlying assets, and other derivatives. Basic strategies for beginners include buying calls, buying puts, selling covered calls and buying protective puts. There are advantages to trading options rather than underlying assets, such as downside protection and leveraged returns, but there are also disadvantages like the requirement for upfront premium payment.
2. MULTIPLE CHOICE TEST QUESTIONS ON COVERED CALLS
1. Which of the following is a covered call position?
(a) Buy call and sell stock.
(b) Buy stock and sell stock.
(c) Buy stock and sell a call.
2. An investor buys stock for $30 and writes or sells a $35 strike call for $2. What is the cost basis or breakeven price for the stock?
3. The quote on an option is Bid $1.00 and Ask $1.10. If you place an order to sell one contract at market what price will you receive?
4. A stock is currently trading at $50 and the $45 strike call is trading at $6. How much time premium is included in the $6?
5. Which of the following orders guarantees the execution but not the price?
(a) Market order
(b) Limit order
(c) Day order
6. If the stock price rises by one dollar. By how much will the price of the call option rise?
(a) It will actually fall.
(b) More than one dollar
(c) It depends on delta.
7. If you place a Limit order to buy 1000 shares at a certain price, is it possible to get filled on less than 1000 shares?
(a) No, all 1000 shares must be filled.
(b) Yes. Partial fills may occur on limit price orders.
8. The underlying stock is trading at $20. Which call option is described as being “In the Money” (ITM)?
9. How many shares are covered by one Option Contract generally?
10. Which Greek name in Option trading represents Time Decay?
MODULE 5 – Correct Answers
A: If you score 9 or 10
B: If you score 7 or 8
C: If you score 6 or lower.
Please read through the text section relating to the questions you answered incorrectly.