Covered Calls
Selling covered calls, or writing covered calls, is one of the more conservative strategies in trading options. It is suitable for new investors to earn additional income and have some control over your positions. As always, risk is involved and experience can only be gained through education and real trades. The advice is based from my limited experience with option trading.
Getting Started
Nothing beats practical and real experience. First, I recommend you to get a practice account with virtual money and test out a few trades. The purpose is to familiarize yourself with the process and terminology. Second, start selling your first call on a safe, large-cap stock with dividend, maybe one of the Dividend Aristocrats. The reason is that volatility on this stock is likely low and in the worst case the stock price goes down, you will continue to own the stock and earn your first option premium and still have some dividends over your holding period. For your practice account, OptionsHouse offers virtual accounts that can trade stocks and options.
Covered Call Evaluator
This
covered call evaluator is designed specifically for covered calls. It will help you answer these important questions:
- Should you roll forward, roll up, or roll down your current covered call?
- Should you buy a stock and sell a covered call together as a multi-leg option?
- How much will you earn by selling a covered call on your existing stock?
- Should you buy back your covered call now to prevent your stock from being called away?
Tips - Good Habits
- Do know when major events happens. Most common are earnings releases and dividends. These events can make the stock moves up/down significantly, which is much harder to predict and take into account in the current bid/ask. Unless you know the direction, it is better to wait until after the event to buy/sell calls.
- Do keep track of the current time premium of your open calls. This helps you to plan to roll, close, or simply let it expire.
- Do have a trading plan with target profit percentage and be happy with it. Do not be greedy. You win some, you lose some.
- Do know your investing style, what makes you feel comfortable. For example: you want to sell out-the-money calls and expect it to expire worthless and earn the full premium. Or you might want to sell in-the-money to have some protection from a possible future downside. The style should also depend on the underlying stock. Nothing fits all here.
- Do understand that profit can be capped with covered calls. You might earn much more without a covered call. This does not sound like a problem until you experience it the first time. For example:
- Do realize the possibility that your position will be called away and plan for it. Dividend stocks fall into this category. If you want to build a dividend portfolio, you might have to sell really out-the-money calls, which likely results in tiny premium and long expiration. Thus, make judgements, do not just pair all your stocks with calls just to get income from them.
- Do realize that the bid/ask spread can make your forward roll more expensive or less profitable
- Do realize that there is an opportunity cost for the money to be locked in, unless it is a position you want to keep for the long term (i.e investment vs. trade) for dividend, growth
Tips - Bad Habits
- Do not initiate a call, Sell-to-Open, on a down day. Even time premium of a call will decrease over time, option bid/ask price follows its underlying security. Stock rises, its option rises. Stock falls, its option falls.
- Do not sell calls on a losing stock just to get some income, or to get break even. When doing this, you are emotional and often sell when the call is cheap.
- Do not sell too far away just to get more money now, you have less control and have to lock your money for a long time. Of course you can buy back before then but that means time premium is wasted.
- Do not Buy-to-Close on an up day. The price is high and if you think a short break is coming, wait instead
- Do not just pair all your stocks with covered calls just to get some income from them. This indiscriminate approach will likely raise your trading costs from commissions and tax treatments.
Good Example - Selling Covered Call on an OVER-BOUGHT position
Let assume you have a really good stock that you keep for dividend. You bought it a while ago and your cost basis is low enough from the current price. I skip tax implications for long/short term and qualified calls here for simplicity. You don't expect this stock to go any higher than the strike price and it is current overbought. Because it is overbought, the recent price has gone up really quick and you are expecting a correction to be coming but is still above your cost basis. At this time, the option premium is high. You should sell an out-the-money covered call on this stock. Thus, you have the best of both worlds: high/peak premium from selling the option now and still get to keep the stock when the call expires. This is NOT a buy/write approach. With buy/write, you're also buying at the high end and the safety threshold above break-even is small. If the stock corrects significantly, you will be at a loss. This is a write-only approach on your existing position.
Of course there are risks associated with this case:
- If the stock goes higher than strike: your stock will get called away. Thus, if you MUST keep the stock then don't even consider selling calls against it.
- If the call are too far away: this creates uncertainty and lack of control. Unless you don't worry too much about the ups and downs and simply check it once/twice a month.
Bad Example - Selling Covered Call on an OVER-SOLD position
If you're impatient and just wish to break even so you sell a call when the stock is still in a down trend, or it is currently oversold. The premium receives likely very small and more importantly, smaller than selling it at a more stable/positive trend. A better approach would be wait until there are some positive news/events on this stock to sell covered call.
Good Example - Selling Covered Call during HOLD-and-WAIT
You bought a stock and it is carrying a loss. You can either exit the position now or wait for it to recover. If you believe in this stock and plan to wait, you can sell covered calls to earn income while you wait. It also reduce the pain and reduce your cost basis. However, timing the covered call is important.
Disclaimer
There are other cases, scenarios, approaches, exceptions that I do not cover or discuss. Please feel free to send me feedback and your own examples to include here.