Covered Calls: Five Steps Towards Making Better Option Trades
by Karim Rahemtulla, Contributing Editor
Friday, July 17, 2009: Issue #1043
The mainstream “press” does not want you to pay attention to option strategies such as covered calls.
There is a conspiracy here – and it’s meant to keep you ignorant to a sector of the market that just doesn’t fit in with the “buy stocks and mutual funds” mantra that makes Wall Street money.
You see, there are no upgrades or downgrades for covered calls, LEAPs, or puts.
It’s because most mutual fun managers can’t see beyond what they have been taught, which has predominantly been to “buy stocks.”
Sure, they’ve heard of options and even know how they work, but they are scared of showing options on their portfolios because the “Average Joe” that invests in mutual funds still looks at options with tremendous skepticism.
They’re dead wrong.
The options market was created for professionals and institutional money managers, who don’t report to the general public, but to their wealthy or sophisticated constituents.
When George Soros took down the Bank of England to the tune of billions of pounds, he did so by using the leverage that options provided him. He saw a trend and figured out how to best capitalize on it with risking less money . If it went against him, he would have lost big, but not nearly as big as someone who was risking it all.
The key to trading options is knowing how to use them to maximize the efficiency of your money. The first – and easiest – strategy for using options is the covered call trade. Here’s how you can use it to separate yourself from the average investor.
Why a Covered Call is “Covered”
In order to execute a covered call trade you need to use both a stock and an option.
The reason it’s called “covered” is because it means that your trade using the option is covered by the underlying shares that you own.
There is no risk to the broker when you execute this trade because if it goes against you, there is protection of equity by the shares you already own. That is why this type of trade can be done by anyone in any type of account, including your retirement account.
When you enter into a conventional covered call trade you are pledging to sell your shares at a certain price (strike price) on a certain date (expiration). For pledging your shares, you will be paid money (premium).
Consider yourself a stock landlord. You are renting your property for any given time, and expect to be paid for it. The money or rent that you receive is yours to keep, spend or reinvest.
In other words, you will have reduced the basis of your stock by receiving money back for the “rental.” Remember that anytime you reduce your cost basis, you have also reduced your risk.
How to Place a Covered Call Trade
An example of a conventional covered call trade would be something like this:
- You buy 1,000 shares of Yamana Gold (NYSE: AUY) for $8.50 per share. You think that Yamana can go to $10 by year’s end. You look at the options chain (a listing of the options available) and find out what the market is buying and selling Yamana’s $10 options for.
- Just like stocks, you buy at the offer/ask and sell at the bid. In this case, you see that the option is trading for $0.90 on the bid and $0.95 on the offer.
- Options are priced in increments of $0.01, $0.05 and $0.10 depending on volume traded, and selling price. In the case of Yamana, this set of options is priced in $0.05 increments.
- Options trade as contracts and each is equivalent to 100 shares of stock. The price is listed in per share amounts but is for 100 shares. So, while the Yamana options are priced at $0.90 by $0.95, the minimum dollar amount that you need to be aware of is for one contract or $90 by $95.
It also means, for the purposes of covered call investing, that you need to own at least 100 shares of Yamana to execute the trade.
- The strike price of $10 means that the buyer or seller of the option is has the right to either buy or sell Yamana at $10 depending on the strategy used and if the contract is bought or sold.
- If the option is sold, as in the case of a covered call trade, the seller of the option is obligated to deliver shares of Yamana to the buyer if the shares close at $10 or higher.
The buyer of the option has the option of taking delivery of the shares or selling the option back into the market.
Getting back to our covered call example, let’s get some other details:
You bought 1,000 shares of Yamana at $8.40, so you paid $8,400. You then sold 10 contracts of the Yamana January $10 call option. (Remember each contract equals 100 shares so for 1,000 shares you must sell 10 contracts.) You sell the options at the bid price of $0.90 receiving proceeds of $900. The $900 comes from 10 contracts, or 1,000 shares, times $0.90 per share.
Your cost in Yamana has now been reduced by 90 cents per share, so it is now $7.50 (8.40 minus $0.90) and the money you received, 90 cents per share is yours to do with what you will.
So how does it all end?
There are three possible scenarios in the works now.
- First, if Yamana closes at $10 or higher at the expiration date in January, your shares will be automatically sold to the buyer of the option at $10 per share, regardless of what price Yamana is trading for, as long as it is $10 or higher.That buyer who you sold the option to was betting that Yamana would close at $10.90 or higher in order for him to make money. Anything less and he loses. The $10.90 comes from the $10 strike plus his cost of $0.90 for the option. If it closes at $10 or higher you will make 33% on your money ($10 strike minus $7.50 cost = $2.50 profit. $2.50 profit divided by $7.50 cost equals 33%).
- If Yamana goes nowhere at stays at $8.40 at expiration you will still make money because you took in 90 cents when you sold the option. Therefore, your return on the trade would be 12% ($8.40 minus $0.90 = $7.50. $0.90 divided by $7.50 = 12%). Since the shares weren’t higher than $10 at expiration, the contract wasn’t executed and it would expire worthless. But you still retain ownership of the shares, free to sell another covered call.
- Finally, if Yamana closes below $8.40, you will still make money since your cost was $7.50. You can only lose money if Yamana closes below $7.50, your adjusted cost and your breakeven point.
Profiting From Covered Calls
As long as Yamana closes below $10, you will retain ownership of the shares and face two options. The first would be to sell your stock and the second would be to sell even more CALL options against your position further reducing your cost. As the owner of the shares you are entitled to any dividends that are paid to shareholders during your period of ownership.
To summarize:
- A covered call trade requires you to own the shares that you then sell options against.
- The money received from selling the options is yours to keep immediately.
- If the shares close above your strike price, they will be taken away (called away) from your account automatically and the money will be deposited in your account.
- Covered calls can be done in any type of account, including retirement accounts.
- Covered call trading can generate additional income while reducing your risk.
Stay tuned over the next few weeks as we break these profitable option trades down even further and we will explore a variation on covered call trading that can reduce your risk substantially while still providing double-digit returns.
Good investing,
Karim Rahemtulla
P.S. If you’re looking for more on these options, take a look at The Instant Money Trader service. It finds some of the most profitable covered calls in the markets.
Related Investment U Articles:
- How to Sell Put Options and Snag the Market’s Daily Deals
- How to Write Covered Calls: Use This Strategy to Kick Your Portfolio into Overdrive
- The Covered Call Strategy: Generating Income From Stocks in Any Portfolio
- How to Recover When Your Option Trades Turn Against You
- The Legged Spread Trade: Take 10 Cents and I’ll Show You How to Make It $2.50
7 Responses to “Covered Calls: Five Steps to Make Better Option Trades”
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Dubbed a "market maven" by CNBC, Karim Rahemtulla is one of the country's foremost specialists in options trading. As founder and editor of The Smart Cap Alert, he focuses his efforts on all aspects of options trading – LEAPS, put selling/covered calls and spreads. 
Excellent article. Where is the options chain for TSX listed stocks.
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can’t options be exercised at any time before expiration, not just on expiration day?
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How can i invest in the oil and covered calls opportunity since i am not resident in USA ?
Thanks
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In following up with the ability to do options I called the Oxford Club to ask their opinion concerning Think or Swim and I was very surprised that Mark, the man who took my call, had never heard of it before. Is there anyone who has experience with Think or Swim and would recommend it?
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This is the website for TSX options chain
http://www.m-x.ca
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I have NTRI 120 stokcs got in at $21. Can I do a covered call strategy on this? if yes, kindly explain how can I do this.
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There is a good covered call tutorial at http://www.borntosell.com/covered-call-tutorial
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