Uncovered Call Writing Explained

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How and Why to Use a Covered Call Option Strategy

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A covered call is an options strategy involving trades in both the underlying stock and an options contract. The trader buys or owns the underlying stock or asset. They will then sell call options (the right to purchase the underlying asset, or shares of it) and then wait for the options contract to be exercised or to expire.

Exercising the Option Contract

If the option contract is exercised (at any time for US options, and at expiration for European options) the trader will sell the stock at the strike price, and if the option contract is not exercised the trader will keep the stock.

A put option is the option to sell the underlying asset, whereas a call option is the option to purchase the option. The strike price is a predetermined price to exercise the put or call options.

For a covered call, the call that is sold is typically out of the money (OTM), when an option’s strike price is higher than the market price of the underlying asset. This allows for profit to be made on both the option contract sale and the stock if the stock price stays below the strike price of the option.

If you believe the stock price is going to drop, but you still want to maintain your stock position, you can sell an in the money (ITM) call option, where the strike price of the underlying asset is lower than the market value.

When selling an ITM call option, you will receive a higher premium from the buyer of your call option, but the stock must fall below the ITM option strike price—otherwise, the buyer of your option will be entitled to receive your shares if the share price is above the option’s strike price at expiration (you then lose your share position). Covered call writing is typically used by investors and longer-term traders, and is used sparingly by day traders. 

How to Create a Covered Call Trade

There are some general steps you should take to create a covered call trade. 

  1. Purchase a stock, buying it only in lots of 100 shares.
  2. Sell a call contract for every 100 shares of stock you own. One call contract represents 100 shares of stock. If you own 500 shares of stock, you can sell up to 5 call contracts against that position. You can also sell less than 5 contracts, which means if the call options are exercised you won’t have to relinquish all of your stock position. In this example, if you sell 3 contracts, and the price is above the strike price at expiration (ITM), 300 of your shares will be called away (delivered if the buyer exercises the option), but you will still have 200 shares remaining.
  3. Wait for the call to be exercised or to expire. You are making money off the premium the buyer of the call option pays to you. If the premium is $0.10 per share, you make that full premium if the buyer holds the option until expiration and it is not exercised. You can buy back the option before expiration, but there is little reason to do so, and this isn’t usually part of the strategy.

Risks and Rewards of the Covered Call Options Strategy

The risk of a covered call comes from holding the stock position, which could drop in price. Your maximum loss occurs if the stock goes to zero. Therefore, you would calculate your maximum loss per share as:

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Maximum Loss Per Share = Stock Entry Price – Option Premium Received

For example, if you buy a stock at $9, and receive a $0.10 option premium on your sold call, your maximum loss is $8.90 per share. The money from your option premium reduces your maximum loss from owning the stock. The option premium income comes at a cost though, as it also limits your upside on the stock. 

You can only profit on the stock up to the strike price of the options contracts you sold. Therefore, calculate your maximum profit as:

Maximum Profit = ( Strike Price – Stock Entry Price) + Option Premium Received

For example, if you buy a stock at $9, receive a $0.10 option premium from selling a $9.50 strike price call, then you maintain your stock position as long as the stock price stays below $9.50 at expiration. If the stock price moves to $10, you only profit up to $9.50, so your profit is $9.50 – $9.00 + $0.10 = $0.60.

If you sell an ITM call option, the underlying stock’s price will need to fall below the call’s strike price in order for you to maintain your shares. If this occurs, you will likely be facing a loss on your stock position, but you will still own your shares, and you will have received the premium to help offset the loss. 

Final Thoughts on the Covered Call Options Strategy

The main goal of the covered call is to collect income via option premiums by selling calls against a stock that you already own. Assuming the stock doesn’t move above the strike price, you collect the premium and maintain your stock position (which can still profit up to the strike price). 

Traders should factor in commissions when trading covered calls. If commissions erase a significant portion of the premium received—depending on your criteria—then it isn’t worthwhile to sell the option(s) or create a covered call.

Put and Call Writing Explained

Learn how to sell calls and puts

Making money in any type of market can be an extremely trying proposition. You’ve got to pick the right stock, pick the right options — oh, and you’re timing also has to be right.

Considering how many components are involved with a successful trade, i.e., how many things you have to get right, why not take greater control of the variables by writing your own ticket?

Writing your own ticket involves writing put and call options. And though the goal of put writing versus call writing is different in a strategic sense, the ultimate goal of increasing your overall gains — along with your overall wealth — is one and the same.

Let’s take a look at how we can make money writing puts, and then we’ll take a look at how to do the same by writing calls.

‘Put’-tin on the Ritz: Writing Put Options

You often hear about a public company making the move to repurchase a block of its own shares on the open market. This is good for shareholders because it reduces the number of shares outstanding, while typically boosting the value of existing shares. It also increases a company’s earnings per share.

When PC moguls Bill Gates and Michael Dell wanted to do a share-buyback program for their respective empires, they took advantage of the options markets to increase the return on their investment. What they did was write (or sell) put options, and by doing so they created a win-win situation with their stock performance.

How was this accomplished?

Well, when put contracts are written, if the stock goes down in value then the shares are “put” to the writer (i.e., to buy from the owner of the shares). But if the market price spikes, as the person who has shorted the puts, you get to keep the premium you collected when you initiated the position (as “selling to open” an options position oftentimes results in an initial credit to your trading account).

Either way, it’s better for the shareholders of a company participating in a buyback because it ultimately means that the company is purchasing its stock back at lower prices, thus increasing the return on the investment for the company and, in turn, its shareholders.

Of course, writing puts isn’t just for the big guys. Individual traders can use this technique to enter into a long stock position.

Just keep in mind that when you’re selling a put option, you don’t expect the stock price to drop below the exercise (or strike) price, nor to increase significantly. That way, if the option owner assigns you to buy the stock, you will do so at the strike price of the option.

So if a stock is trading for $25 and you short a $22.50 put, if the share price dips to $22.50 and the option holder “puts” that stock to you, then they’ve saved you the legwork of making the purchase and you’re now the owner of the stock you were planning to buy anyway.

The ‘Call’ of the Wild: Writing Call Options

Often investors cite their fear of risk as the reason why they might shy away from trading options. And while the level of risk can increase with some of the more complicated options strategies out there, that’s not the case with writing covered calls.

In fact, writing covered calls is one of the most frequently used and safest options strategies, because it is one of the most conservative plays a trader can make.

On the surface, writing covered calls seems like hitting a home run. Also known as a “buy-write,” this strategy involves selling call options against stock that you already hold long.

When you sell an option, you immediately collect a premium up front, and because options settle in one business day, the credit you collect hits your trading account a day later. It’s like you get to make money just because you decide to.

Suppose you’re sitting on 1,000 shares of the hypothetical XYZ Corp. with the stock currently trading at $34. Suppose the shares are trading pretty steadily and haven’t made a significant jump in a while.

Instead of waiting around and hoping for the stock to receive its own version of a stimulus package, you can take the opportunity to sell calls at the $35 strike against your position.

Let’s say the XYZ Oct 35 Calls trade at $1.95 per share. That’s $195 per contract, and as one contract covers 100 shares, you can sell a 10-lot, or 10 contracts, for $1,950, so that’s the amount of money that you would take in by selling your calls.

Why the XYZ Oct 35 Calls? Well, for two reasons.

One, the strike price is higher than the current market value, which means that you are agreeing to sell your shares for $35 each should the buyer wish to exercise his or her right to buy the stock (i.e., call it away from you). This means that in addition to the $1,950 that you took in, you’d be selling the shares for $1 more than the level where they’re currently trading.

Two, insofar as choosing the October calls, their expiration date is far enough away that if you are expecting the stock to move up (so that the options become more valuable), you’re giving yourself enough time to be right.

But what if the stock doesn’t go up to, or through, that $35 strike by that third Friday in October?

Well, then you’d keep your premium money — as well as your stock — because the option buyer wouldn’t want to call the shares away from you at a cost that’s above the market price. His or her option would likely expire worthless.

Owning stock and selling covered calls against it is like having an apartment building and collecting rent on the available units. If you can’t find tenants or just haven’t gotten around to renovating a perfectly usable space, then you’re not making any money. And in neutral markets, not collecting “rent” with options trading means you could be passing up a lot of gains that you might never see by just holding on to the stock and playing the waiting game.

Uncovered Call Writing Explained

As my free gift to you, I’d like to give you a complimentary copy of my latest e-book, 35 Mistakes to Avoid in Your Writing.

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