Tuesday Trading Tutorial - Writing Covered Calls - December 9, 2008

After last week’s discussion on the process of exercising options, this week’s topic will delve deeper into a specific trading strategy, writing covered calls.

A trade involving a covered call consists of a long stock position with the writing (selling) of call options against it. This strategy is best suited in a highly volatile, bullish-to-neutral market wherein an increase in the market price of the underlying stock is expected.

Profits are the name of the game, and when using covered calls, these profits are obtained from the credit received from the option’s premium at the opening of the trade. For example if you purchase 100 shares of a stock at $14 and sell a $15 call option for $0.75, you pocket $75. This has the effect of bringing your cost basis on the stock purchase down to $13.25.

Writing covered calls helps provide protection against any decreases in the price of the underlying stock. This allows investors to withstand declines in the stock’s price due to the premium received when selling the options.

Since the majority of the profits made on covered calls come from the premium received, it is paramount that the premium received is priced high enough to offset the risk involved in the trade.

When looking for a covered call play, investors typically look for options priced out-of-the-money (OTM). The most beneficial period to trade covered calls would be with those options that have no more than 45 days until expiration.

Even though the premium received would be greater by selling covered calls with expiration dates several months away, it is generally better to sell a front month covered call and, if you are not called away, do it again in the second and third month. Each month you sell the covered call reducing your cost basis.

In the chart below you can see the premium listed for two months worth of calls. Although the February 55 call has much premium than the January 55, it only allows the price of the stock to move $3.50. This is a small move before the possibility of assignment occurs.

So, what is your possible profit on a covered call trade? As discussed above, there is the premium you receive when you sell the covered call. For instance, if an investor were to buy 100 shares of QWE stock at $51.50, while selling (writing) 1 covered call contract on the January 60 call, the investor would receive $2.10 in premium. The profit to be made from the trade would be $210, ($2.10 x 100).



Call Strike Price January February
45 11.40 13.60
50 7.50 10.10
55 4.30 7.20
60 2.10 4.90
65 0.80 3.10

In addition, if the stock were to be called away at $60, there would be an additional profit of $850. This $850 is obtained from selling the 100 shares at $60 after purchasing them for $51.50. Therefore, the total profit from the trade would be $1060, $210 from selling the covered call and $850 from selling the stock.

When writing a covered call you need to consider your exit strategy. Because covered calls only protect the writer if the stock remains within a certain trading range, it is crucial that the investor keeps a close watch on the stock’s price on a daily basis.

When exiting the trade, a few scenarios may take place. First, if the stock increased above the $60 strike price, then the option will be exercised and the investor must deliver the shares at that price, the $60. Read more about exercising options here.

A second possible outcome is if the stock remains below the $60 strike, then the contract will expire worthless and the entire premium is obtained. The contract writer (seller) will be able to retain the entire premium obtained.

The final possible outcome is if the stock price retreats below the purchase price. The investor will still show a profit as long as the stock stays above the reduced cost basis of the stock. For instance, in the example above, the stock was purchased for $51.50 and a covered call was sold for $2.10 so the new cost basis for the stock would be $49.40. As long as the stock price stayed above the $49.40 mark, the trade would show a profit.

Check back next week when we explore a similar trading strategy, writing naked puts. Have a great week in trading and hope to see you next week.

For more information on the stock and options markets check out the wealth of information at BetterTrades.