Investing with Options – The Covered Call

In Options by Gen Y Finance Guy23 Comments

Reading Time: 7 minutes

Over the years I have taught many friends and co-workers about stocks and options. This was actually one of many impetuses for me to start this blog. Too many people are fooled into believing that options are too risky and complicated. This just isn’t the case and I want to help take your investing to the next level.

If you truly want to be a self-directed investor, you need to understand how to use options in your portfolio. Even the great Warren Buffet uses options in his investing activities and that’s from a guy that likes to keep things simple. I am going to show you how investing with options can be very simple.

In February I laid out rule number 1 of 10 of the investment rules I use to guide my participation in the financial markets. In that post I proposed that options are not nearly as risky as the financial media and the so called experts make them out to be. Although they can be risky if you use them in the wrong way, so can stocks. Risk is a function of education in anything that you do. If options are used correctly, they will reduce your risk, increase your probability of profit, and give you more than one way to profit.

In the follow up post to rule #1 I also gave an example using a covered call. So I thought it would be a good time to circle back to give you the basics of the covered call so you could start using it in your own arsenal of strategies.

Where do we start?

I will assume that everyone know what a stock is and what it represents.

But let me define what a call option is:

call is a financial contract between two parties- a buyer and a seller. The buyer has the option but not the obligation to buy a certain quantity of the stock (underlying) from the seller for a defined price (strike price), by a certain date (expiration date). The seller has the obligation to sell the underlying if the buyer exercises his right. The seller collects a payment (premium) from the buyer in return for taking on such an obligation.

Note: in almost all cases we want to be the seller of the option. The reality is that 80% of options expire worthless, which as you will soon see is a good thing for the covered call strategy.

Example: Let’s look at an analogy that will make this easier to understand. Let’s say that you are in the market for a used car. You find a listing on craigslist that you want to check out. It is a 2011 Hyundai Sonata with 60,000 miles on it and it is listed for $10,000. This could be the perfect car, so you call up the seller to go check it out. You check the car out in person and take it for a test drive and decide this is the car for you. The only problem is you don’t have $10,000 on you to pay for the car.

You tell the seller you want the car but you won’t have the money until the end of the week. However, you are willing to give him $500 now and $10,000 at the end of the week ($500 more than asking). The seller agrees to hold the car until the end of the week in return for the non-refundable deposit of $500. Even if someone came along and offered him $12,000, he is obligated to reject that offer until the end of the week.

This is exactly how a call option works. You locked in the price of $10,000 (strike price) for the car, regardless of someone else offering him more money (or if the stock goes higher). You have until the end of the week (expiration) to exercise your right that you paid $500 for. As the seller, you collected a premium for taking on the obligation of selling your car for $10,000.

Does that make sense? Feel free to ask me questions below to help clarify anything that is still a little fuzzy.

The Covered Call

In my opinion, after you have a basic understanding of call options the first strategy to deploy is the covered call. Even if this was the only strategy you ever employed you would have an edge over 80% of the other retail investors out there.

The covered call is a natural “first” strategy because it is the closest thing to doing what most people understand well – and that’s buying stock with only one difference.  Now we are going to sell a call against that stock that limits our upside, while at the same time providing us with a reduction in cost basis and an increased probability for success.  I like to call the reduction in cost basis the “cushion” or “downside protection.”

Don’t worry, we are not giving up all of our upside! You get to decide how much upside you are willing to give up. As you will see in the example below, whenever you initiate a covered call, you will always know the maximum profit you can make. Remember though, there is always a tradeoff. In this case we are willing to reduce risk, increase our probability of profit, and give our position more than one way to win. The tradeoff to all of this is a defined upside. You will not be giving up as much as you think. How often do stocks really explode to the upside?

Let’s take a look under the hood and see what is really going on with the covered call. We will use INTC as the example, which is actually a real covered call I did back in March of 2013.

To provide a little context, INTC was trading right at $21/share and was looking to sell the March 2014 (expiration) call for $1.15 at the $22 strike. Additionally, INTC pays a 5% dividend. Ok, so what does all this mean?

We all understand that if we buy a stock that we make money if it goes up in value and we lose money if it goes down in value. I think we can all agree on this.

Scenario 1: no options involved

Let’s first take a look of what the risk/reward potential looks like with being long or buying 100 shares of INTC at $21.

Risk: $2,100 price you paid for the 100 shares (21 x 100), stock could go to zero (theoretically)

Reward: Unlimited Upside & a 5% dividend

Break Even: $19.95/share. Assuming you hold for one year and collect the full dividend for a year. ($21 – (5% x 21))

In this example, you basically have a 5% cushion from the dividend and unlimited upside potential.

Scenario 2: using the covered call strategy

Now let’s take a look at the covered call and how it changes the dynamics of the position. We will now buy 100 shares and sell 1 $22 strike for $1.15/share

Risk: $1,985 price you paid less the premium you collected for the call (21 x 100 – 1.15 x 100) (notice that your risk is $115 lower in this scenario)

Reward: $215 & a 5% dividend = $320 max gain if called away or 16.1%.

Break Even: $18.80/share. Again assuming you hold for one year and collect the full dividend. ($21 – (5% x 21) – (1.15 x 100))

There are major two differences between the two examples that I just outlined above:

  1. By selling a call against your shares you are capping your upside at $22/share in return for $1.15/share. So you are collecting 5.5% for obligating yourself to sell your shares at $22 should INTC trend higher above this strike by expiration. So you have essentially locked in a max gain of 16.1% (not a bad annual return if you ask me)
  2. By selling the call you have not only doubled your cushion or downside protection from 5% to 10.5% you have also increased your probability of success, giving you an edge over the majority of other market participants. What I mean is that the stock could fall 10.5% by expiration in March of 2014 and you still would not be down any money.

Note: In most cases you will want to sell a call that is ‘out of the money,’ which means the strike price of the call is greater than the current price of the stock.

I don’t know about you, but I am willing to cap my gains at 16.1% for the extra downside protection. And there is also a very possible scenario that INTC does not trade higher by expiration, which would allow you to both keep your stock and the premium you collected. Then you can turn around and do it again. I have had some stocks where I have done this so many times that my cost basis is getting really close to zero.

Note: At the time of this investment, the call had a 65% probability of expiring out of the money by expiration. Meaning there was only a 45% chance that I would ultimately have to sell my shares to the buyer of the option. And in reality the buyer is not likely to exercise his option unless the stock is at least $1.15 in the money (based on the premium he paid you). This is because his breakeven is $23.15 ($22 strike price + $1.15 premium paid). He is better off to sell his option back in the open market to close his position.

By the way, you can sell options monthly if you want. I just gave the annual example because it made it easy to put things in terms of an annual return.

Take away

Like I said above, if you do nothing else but the covered call, you are going to do better than 80% of the investors in the market place. I look at covered calls as a way to enhance my returns. And if a stock doesn’t pay a dividend, this is a way to create a synthetic dividend.

When initiating a covered call you are effectively buying the stock for less than the market price because of the premium you received.

Let me know what questions you have in the comment section below. I know there are plenty of questions out there. And my hope is that you will ask your questions and I will be able to use that to expand on this strategy further in future posts. I also promise to reply to each comment. I appreciate you taking the time to read this and leave your comment below.

– Gen Y Finance Guy


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They also provide a ton of educational resources that are free to you. You will also have access to stocks, options, futures, and forex all on a single platform. And if that wasn’t enough, they will let you invest commission free for 60 days while you test drive the platform and they will give you up to $600 for rolling over your other accounts.

My special offer to you: If you sign up for an account using the links I provided on this post, I will send you a video that gives you an over view of the Think or Swim investing platform and I will even show you how easy it is to execute your first covered call. All you need to do is sign up using the banner below or the TD Ameritrade link above, then send me an email at mrgenyfinanceguy@gmail.com

p.s. once your account is open if you tell them that Tasty Trade sent you and reference promo code #233 you can secure exclusive commission rates: $1.50/option contract & no ticket charge, and $7.00 flat rate stock trades



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Comments

  1. I’ve always been a fan of stock options. In fact, my first employer straight out of college offered a generous “first time buyers” program (as they were employee-owned at the time), which included a great deal of options if you spent the $5k to buy in. Of course, I happily did, though at the time, I cringed at spending those 5 Gs on something other than a bunch of crap. 🙂

    As always, nice post.

    1. Author

      Thanks Steve!

      As you probably know, the stock options your employer offered work a bit differently then what I am talking about here.

  2. I definitely understand the benefit of a covered call, but I don’t partake mainly for two reasons:
    1) Limiting upside as you discussed
    2) Taxed as short-term capital gain which is at your ordinary income tax rate.

    One question: You noted 65% chance of the option expiring out of the money. Who derives that percentage? In reality no one knows where INTC is going to be in a year. I don’t think I would let those percentages play a part in the decision to sell a call.

    1. Hi FF,

      I believe that the probabilities are usually derived by past volatility and the assumption of the “random walk” movement of the market being true–i.e., if the stock moves an average of $5 a year, and it’s currently at $20, it would be equally likely to be at $15 as $25 by the end of the year (according to the theory underlying the odds calculator).

      For my own purposes, the estimated odds are a good first step for buying/selling options, but I think they become progressively less accurate the farther out you look. Of course, it could all be market voodoo!

      Keep on saving,
      Charles

      1. Author

        Hey Charles,

        Your right it is just estimated probabilities based on known variables using the option pricing model. And if you are systematic and have enough number of occurrences a probability based approach to the markets will be profitable over the long-term. It is the same reason insurance companies make money. They price premiums based on the probability of certain events occurring.

        Cheers!

    2. Author

      Hey FF,

      I think most people have a hard time getting around limiting your upside. It is certainly a trade off to collect the option premium. Unlimited upside is alluring, but I think the trade off is well worth it. Anytime you can reduce your cost basis you increase your probability of profit.

      Taxes are only an issue in an after-tax account. All of my investments in stocks are currently held in private IRA’s and a 401K. So taxes are not even considered at this point.

      You are totally right that no one knows where a stock will be…that is why they call it a probability and not a guarantee :). All probabilities are calculated using the option pricing model (they are dependent on many variables). I happen to use Think Or Swim from TD Ameritrade that does the heavy lifting for me. It’s a little too much for me to go into detail in this comment. In a nutshell the variables that go into the pricing model allow you to calculate probabilities.

      If you want to read more on options theory, I’d recommend Option Volatility & Pricing by Sheldon Natenberg.

  3. GYFG,

    Excellent illustrations in explaning cover calls. I don’t document my options trades on my blog, but I currently have Jan 16 calls on BP and VZ. I also recently sold Sept 15 calls on GE after its big spike last week. I sold a couple of in the money $22 calls with $5.89 premiums believing that GE will drift downward. So far it has. If I lose the shares, no big deal as it is my second largest position and its recent dividend increase was disappointing.

    Also regarding your INTC example, that is one of the cases where you could have lost some of the upside gain. After a couple of years in the low 20’s, in 2014 it led all DJIA stocks by surging up to the high 30s. I typically buy “Dow Dogs” as I like reversion to the mean stock buying strategies. I’m sure last year many calls were sold in the mid to high 20s and a lot of profit potential was lost. I ended up selling my INTC shares around $34 due to the frozen dividend thoughout most of last year. I didn’t have any INTC options fortunately.

    Anyway, I look forward to you next articles covering option strategies. I currently sell calls against shares that I own as this is safe and relatively easy to understand.

    MDP

    1. Author

      Thanks MDP!

      Nice job on INTC. Yes, I definitely left money on the table with this one. But you know what they say “non one ever went poor taking a profit” 🙂

      I did end up making the same investment a few times. If I remember correctly the last time the stock got called away was around $28/share in 2014.

      Selling puts would be a natural next strategy to add your your tool chest. The risk/reward profiles are exactly the same. It just depends on what you are trying to accomplish. I sell puts around price levels I don’t mind getting long.

      Cheers!

  4. GYFG, that was a very clear explanation on covered calls – which is something I’m pretty unfamiliar with. Although I have no immediate plans to trade options, this may be extremely useful in the future.

    Definitely looking forward to reading more technical posts like this.

    I’ve learned something new today. Thanks.

    1. Author

      It’s my pleasure Josh. Glad you enjoyed the post.

      Plenty more technical posts to come on investing and using options. Just need to release it slowly so I don’t drown people 🙂

      Cheers!

  5. Thanks for the very clear explanation. I never really understood exactly how it works nor did I really try to understand as the mainstream media did make it seem like it was something that was risky or for professionals. That’s one of the many things I enjoy about pf blogs, you learn a lot of things and have a different perspective. This is definitely one of those posts…another was when Financial Samurai said that a 30 year fixed is not always the best and an ARM may be a better choice depending on your situation while the mainstream media says 30 yr fixed is always right and an ARM is risky.

    1. Author

      Thanks Andrew.

      I am glad you enjoyed the post and that I could expand your knowledge a bit. I too like that about the many PF blogs out there.

      I use to be in the same camp about adjustable rate mortgages, but they are a cool tool if you use them right.

      Options are the same way. There are plenty of ways to misuse them. But there are certain strategies like the covered call that are simple and actually reduce risk.

      Let me know if you ever decide to try this out and if you have any questions. I am more than happy to help 🙂

      Soon I will post about the cash secured short put which is a synthetic equivalent of the covered call (less commission).

      Cheers!

  6. Covered calls work well in a flat or up-trending market. But in a declining market they carry a heavy risk:

    You own INTC at $41 and sell an option at $43. Stocks start to roll over and you keep the premium.

    When INTC is at $37, you sell a $39 call. Stock head-fakes back up to $40, it gets called away and now you’re stuck with a capital loss.

    That was a very quick scenario off the top of my head, but I just wanted to illustrate that there are complexities to this. I believe its a viable strategy if applied judiciously, but there is definitely some added risk.

    Savvy option players will exercise in the money calls on dividend payers right around the ex-dividend date so that risk is even higher if you’re employing a covered call strategy with high-yielders.

    1. Author

      Hi No Waste,

      Thanks for the comment.

      To keep people from getting confused, I would add that your example is correct only if the total premium collected is less than $2/share. I am not saying that is not possible, only that a capital loss is not guaranteed. But you bring up a good point. You should always consider you cost basis before selling a covered call.

      You bring up good things to consider when selling covered calls.

      Cheers!

  7. GYFG,

    Found your site on My Dividend Pipeline’s blog. Excellent post. I’ll definitely be following you in the future. Always great to follow another options investor. I’m 31 so usually they are all older than me! How did you get started trading options so young?

    I’m mostly doing dividend investing but have begun selling puts and calls as well. I’m using thinkorswim and dough (created by the thinkorswim creators). Do you watch the tastytrade shows?

    1. Author

      Hey Scott,

      Thanks for the kind words. MDP is a good guy.

      Glad you enjoyed the post and stoked you found my blog 🙂

      I started investing when I was in college and started trading options back in late 2006. I also use the thinkorswim platform. It really is the best retail investing/trading platform out there in my opinion. I actually learned a lot from Tom Sosnoff before he ever started the TastyTrade network. I love what he is doing there.

      I met Tom for the first time at the traders expo in LA back in 2010 I think. I actually ran a options trade book for profit for a big oil company for a few years and it was cool to be able to bounce ideas off of Tom back then.

      I typically tune in to TastyTrade for the last call at the end of the trading day. I also have a dough account, but I never use it. I really prefer the TOS platform.

      Looking forward to seeing you around.

      Cheers!

      1. Wow! That’s awesome that you got to meet Tom. I’m moving to the West Loop in Chicago in July for work and am definitely going to be trying to hit up his favorite BBQ places in Chicago. It would be great to run into him.

        Do you have any blog posts talking about the start to your options trading in 2006? Sounds like it would be a fun read.

        I have TOS installed but am kind of a visual guy so the dough platform is quite nice. They’re constantly updating it to make it more powerful, but TOS, particularly with scripts added to it, is still really nice to have.

        Scott

        1. Author

          I do not have any posts on the blog yet talking about the history of my options trading. I actually only launched my blog about 7 months ago and have only briefly touched on anything options related.

          I am leaking that kind of stuff out slowly in order to not overwhelm readers who are not very familiar with options.

          But you bring up a good idea for a post or series of post with my evolution into options. Future post to come.

          Cheers!

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