In this video tutorial, I want to talk about a covered call spread. Covered calls are for the long-term stock investor that is looking for a steady or a slightly rising stock price at least for the term of the option.
This is a capital intensive strategy because you have to be long at least 100 shares of stock to sell a traditional covered call.
Really, this is where most people get started in making the transition between options and strategies and moving away from trading stock just by itself and using some options and strategies in conjunction with stock.
I agree that if you're going to be a stock trader and stock investor, you've got to have some covered call strategy inside your portfolio because it’s just the smart way of making trades.
Let’s talk about how you setup a covered call specifically. The first thing that you’re going to do is you’re going to be long 100 shares of stock or you’re going to buy 100 shares of stock.
In this case, you may already have 100 shares of stock, so in that case, you already meet that requirement, but if you don't have those shares of stock, you do have to buy 100 shares of stock to do this strategy.
This is why it’s a little bit capital intensive when you get started. Once you have those 100 shares of stock, you can sell one out of the money call against those positions or that position of stock.
Basically, the reason it’s called a covered call is that that one option covers 100 shares of stock, so now your position is covered on both ends. What's the risk?
Because you are still long 100 shares of stock, your risk is still in the decline of the stock past your new breakeven point as it heads lower. Selling the call option helps reduce the cost basis of the shares that you own.
This is really the main benefit to doing a covered call strategy and one that we’ve talked about a lot both in our blog and in our podcast that it reduces the cost basis of the shares that you purchase and actually leaves you a little bit of wiggle room for the stock to move down and still make some money between now and expiration.
We’ll show you a good example of that here in a little bit. As far as profit potential, covered calls do have a limited profit potential to the difference between the strike price and the stock price plus the credit received from selling that out of the money call.
Although these are limited in profit potential, they make up for that in a higher chance of success overall on the trade. Because we’re moving our breakeven point lower and our cost basis on the trade lower, this gives us a greater probability of success overall going forward.
Since we are short, a naked option and the stock is not affected by volatility, increasing implied volatility does hurt this position. What that means is that we want to try as much as we can to target the strategy when implied volatility is high in the underlying stock that we’re trading and this gives us the best edge in the market.
As far as time decay or Theta, the passage of time as we get towards expiration does help this position since we are a short premium that we received on the sale of the call.
The closer and closer we get to expiration, we ideally want to keep all of that premium that we received on the call option and the closer we get to expiration, the faster this will materialize.
As far as breakeven points, they’re very easy to calculate. You take the long stock price minus the credit received on the sale of the call. This is where we reduce the cost of owning the stock by selling a call.
We’re going to take a look at an example here using the stock ticker symbol USO. USO is an ETF that trades and tracks an oil fund for the US. Again, that ticker symbol is USO. The stock has been beaten down recently as of the time of this video.
It’s down around 17.77 as far as a price. That’s where it closed today. When we go in here to do our covered call, the first thing that we have to do is own the underlying shares of the stock. In this case, we don’t own the stock, so we’re going to go ahead and buy the stock at that price of 17.77 where it closed today, and we’re going to buy at least 100 shares of stock.
This creates a lot of capital requirement in our account because we have to cover that trade, but this is how we build that covered call. The next thing that we're going to do is we’re going to try to sell an option that's out of the money.
In this case, we’re just going to go ahead and sell the next nearest option out of the money which is the 18 calls above the market. For those calls, we should get about $1 for those once the market opens up tomorrow, so we’re going to go ahead and place that order here for about $1, and it’s about two pennies higher than where it closed today.
That 18 call then helps reduce the cost of owning the shares by $1 which is that credit that we received. When we look at the payoff diagram here, you can see it looks just like the one that we had in the slides before, it’s got this steep angle on the left side.
This is basically where you own the stock, this is your stock profit and lost curve and then it flattens out here right at the strike price of 18. You can see that strike price of 18 is where it flattens out because you sold a call at 18. You are capping your profit beyond this point.
You can’t make any more money should the stock go higher. But now, the benefit to doing that is you cap your upside potential in this trade, and you’re capping it to about $110 in this trade, is that you move your breakeven point down or lower from where it’s at right now at 17.77, you move it down by a whole $1.
In this case, USO can fall another $1, and you still would be okay at expiration. You wouldn’t make or lose any more money than you do right now. If USO fell less than $1, then you still make money at expiration, and if USO moves higher, you still make money at expiration.
This is why when trading covered calls, it's so important to realize that that reduction in cost basis or the reduction in the cost of owning the shares using that credit to offset that price helps you in your increased probability of success. Most people don't get that concept, but it's so critical to your ability to do this long-term.
One of the key takeaways that we have for covered calls is that you should always remember that if the stock should move past your out of the money call strike at expiration, in our case with USO, it’d be moving past that 18 call strike, you will forfeit your stock to the other party in the transaction.
That’s why it’s called a covered call because you're covering that trade with the shares that you already own. In that case, the shares will be taken directly out of your account, and you’d have to re-buy the shares at some price in the future.
But that's okay if that happens because that means that the stock made a huge move and you’ve already banked a profit anyway, you just didn’t realize all of the profit from the stock moving higher. We don't favor these strategies because of the higher capital requirements.
We think that there are other ways that you can get the very same profit loss diagram and the same risk-reward features as doing a covered call but with a lot less capital on the line. That's one of the ways that we use and teach options inside of our membership area at optionalpha.com.
Even though this is a great strategy for long-term investors, we feel that there are better ways to make money trading this same profit loss diagram with much less capital. As always, I hope you guys enjoy these video tutorials.
If you have any comments or questions, please add them right below here on the lesson page. Until next time, happy trading!