Covered Call Strategies

Published August 29, 2011

| TradeKing

NOTE: This graph indicates profit and loss at expiration, respective to the stock value when you sold the call.THE STRATEGY

Selling the call obligates you to sell stock you already own at strike price A if the option is assigned.

Some investors will run this strategy after they’ve already seen nice gains on the stock. Often, they will sell out-of-the-money calls, so if the stock price goes up, they’re willing to part with the stock and take the profit.

Covered calls can also be used to achieve income on the stock above and beyond any dividends. The goal in that case is for the options to expire worthless.

If you buy the stock and sell the calls all at the same time, it’s called a ”Buy / Write.” Some investors use a Buy / Write as a way to lower the cost basis of a stock they’ve just purchased.

TIPS

As a general rule of thumb, you may wish to consider running this strategy approximately 30-45 days from expiration to take advantage of accelerating time decay as expiration approaches. Of course, this depends on the underlying stock and market conditions such as implied volatility.

You may wish to consider selling the call with a premium that represents at least 2% of the current stock price (premium ÷ stock price). But ultimately, it’s up to you what premium will make running this strategy worth your while.

Beware of receiving too much time value. If the premium seems abnormally high, there’s usually a reason for it. Check for news in the marketplace that may affect the price of the stock. Remember, if something seems too good to be true, it usually is.

THE SET UP

• You own the stock
• Sell a call, strike price A

Generally, the stock price will be below strike A

WHO SHOULD RUN IT

• Rookies and higher

NOTE: Covered calls can be executed by investors at any level. 

WHEN TO RUN IT

Bullish Neutral You’re neutral to bullish, and you’re willing to sell stock if it reaches a specific price.

BREAK-EVEN AT EXPIRATION

Current stock price minus the premium received for selling the call.

THE SWEET SPOT

The sweet spot for this strategy depends on your objective. If you are selling covered calls to earn income on your stock, then you want the stock to remain as close to the strike price as possible without going above it.

If you want to sell the stock while making additional profit by selling the calls, then you want the stock to rise above the strike price and stay there at expiration. That way, the calls will be assigned.

However, you probably don’t want the stock to shoot too high, or you might be a bit disappointed that you parted with it. But don’t fret if that happens. You still made out all right on the stock. Do yourself a favor and stop getting quotes on it

MAXIMUM POTENTIAL PROFIT

When the call is first sold, potential profit is limited to the strike price minus the current stock price plus the premium received for selling the call.

MAXIMUM POTENTIAL LOSS

You receive a premium for selling the option, but most downside risk comes from owning the stock, which may potentially lose its value. However, selling the option does create an “opportunity risk.” That is, if the stock price skyrockets, the calls might be assigned and you’ll miss out on those gains.

AS TIME GOES BY

For this strategy, time decay is your friend. You want the price of the option you sold to approach zero. That means if you choose to close your position prior to expiration, it will be less expensive to buy it back.

IMPLIED VOLATILITY

After the strategy is established, you want implied volatility to decrease. That will decrease the price of the option you sold, so if you choose to close your position prior to expiration it will be less expensive to do so.

POWERED BY

Options involve risk and are not suitable for all investors. Click here to review the Characteristics and Risks of Standardized Options brochure before you begin trading options. Options investors may lose the entire amount of their investment in a relatively short period of time.

Multiple leg options strategies involve additional risks and multiple commissions, and may result in complex tax treatments. Please consult your tax adviser.

TradeKing provides self-directed investors with discount brokerage services, and does not make recommendations or offer investment, financial, legal or tax advice. You alone are responsible for evaluating the merits and risks associated with the use of TradeKing's systems, services or products.

URL

http://www.foxbusiness.com/investing/2011/08/29/covered-call-strategies/