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Intro to Trading Covered Calls

by | Feb 15, 2022 | Strategy

What are Covered Calls?

Covered calls are just about the most popular options trades whether you’re a beginner starting out learning how options can supplement your stock holdings or if you are a large fund using covered calls to overwrite long term stock positions. An investor can use the strategy as a way to collect more yield on a stock position and it can also be a way to trade long stock bullishly short term in a higher implied volatility market. Covered calls can even be used in IRA accounts.

With covered calls, you are buying 100 shares of stock and selling a call against those shares to reduce the cost basis of the shares. Since you are long stock there is no “naked risk” to the short call because it is “covered”. If you simply sold a naked short call you would be exposed to unlimited losses on the upside if the stock rallied through your short call strike. However, when trading covered calls (or sometimes called covered stock) you are willing to sell at that strike price, or be “called away” from your shares. Ideally you collect a nice credit for that sale of the call option so you can enhance your returns on the covered call. The best way to ensure you do that is to focus on selling covered calls in a high IV environment since a more volatile market will come with much higher juiced options premiums. This also makes it possible to sell a covered call strike even further away from the current stock price compared to a lower volatility market environment. 

The trade off here is the upside profit potential being limited since gains from the long stock are capped above the short strike call option you sold. If you were long 100 shares of AAPL, then you could sell 1 call option covered in AAPL. Since each option is theoretically equal to 100 shares of stock. Also many people think that selling a naked put is far more risky than trading a covered call but it is theoretically the exact same risk profile when you break it down. You are just putting up more capital to own 100 shares of stock compared to selling a put. But of course there might be other reasons such as dividends that you would want to own shares outright and sell covered calls against the stock for monthly income. The example below in AAPL shows the profit and loss graph for selling a covered call in AAPL at the 180 March strike. You are long 100 shares and selling the 28 delta call so this changes your position delta to near 72 shares. Overall the profit is capped at the 180 strike you sold for $2.20 in premium. But if AAPL stock can be bought today at 172.79 (closing price on 2/15) and you take in a credit of $2.20 that reduces your cost basis to under 170. If your stock gets called away at 180 in 30 days at March expiration that’s a return of nearly 6% in a month without having to do one thing. Many investors would be very happy with that outcome which can be repeated monthly.

 

 

Covered Call Characteristics

Directional Lean: Moderately Bullish Bias

Best Market Environment: High Implied Volatility Market with Choppy Sideways to Higher Bias 

Ideal Setup: Selling the Short Call into a Rally

 

Covered calls can be initiated simultaneously with long stock or you can own stock prior to selling a call and repeat this monthly. It really depends on your position and personal assumptions on the stock. Oftentimes institutions will overwrite long stock at the same time they buy shares so it’s a “stock tied” position and still considered bullish. This is because if a trader buys stock and sells an at the money or out of the money call against it, they are still putting on a long delta overall position, the shares are only partly hedged. 100 shares of long stock and a 50 delta short covered call still equals 50 long delta’s equivalent. However if the stock overwriting or “call sale” is done after a big run higher into resistance it can be seen as a cautionary sign that a fund is willing to be called away at that level since they may assume the stock is likely reaching a ceiling.

Either way, when you put on a covered call initially you are bullish and even though you are capping your upside when selling a call against your shares, you still want the stock price to rise further. If you are fine with being called away from shares at the strike price you sold then there should be no reason not to be bullish. If you get to collect a credit for selling the call and sell your shares at the strike price you sold, it’s the best of both worlds. The key here is being willing to sell your stock at a predetermined price. However since options have time value associated with them the further out in expirations you go, a trader will always have the option of adjusting or “rolling out” the short covered call strike to a further month expiration to avoid being called away if they choose. This only becomes difficult if a stock goes on a parabolic run higher and you are unable to roll the covered call out far enough for a credit. Ideally you are never paying a debit to roll a short covered call. 

The best market environment for covered calls is basically any market or stock that is not going up in a fast manner. Most of the time markets go sideways in a wide choppy range until they start to trend. Those trends are where long stockholders can make a lot of money. So avoiding selling covered calls in a strongly trending market is best, especially since these trending up markets tend to have lower implied volatility as well. This will limit the amount of premium you are able to collect for selling a covered call. So it’s ideal to focus on covered calls when there is more perceived risk in the markets and you are being compensated for selling that upside potential. The simple way to judge this is by looking at a chart and seeing where resistance is in a stock going back 6 months to 1 year. Also taking a look at the range of implied volatility in the stock or overall market for the past year. If implied volatility is in the upper half of the yearly range then it may be worth overwriting your shares by selling a covered call.

At-the-Money (ATM) or Out-of-the-Money (OTM)?

A big question is always which strike do you choose to sell your covered call? It really comes down to the individual overall but there are pros and cons to both. Selling a more near the money covered call limits the upside but also will take in much more credit with the option premium. Selling further out of the money collects less credit but also gives a higher probability of expiring worthless and your shares not being called away. If you prefer to be called away sooner then it would pay to go for that juicier at-the-money option near a 40-50 delta. If you are a longer term stock investor and just want to use covered calls as a way to enhance yields then perhaps you are better off focusing on selling out-of-the-money calls at between the 20-30 delta. Remember a 25 delta option has a probability of expiring worthless about 75% of the time. But a 25 delta option strike also has about 50% probability of being touched before expiration. Personally, if I use covered calls I like to use the chart technicals to guide me as to what price level I would prefer to be called away from. If I see heavy resistance at a level that represents the 30 delta option then I’m fine using that strike because I have a technical focus first off the chart. In our above example using AAPL we used the 28 delta call in March and this 180 strike price level also represented large resistance in the stock the last several months.

How Many Days to Expiration?

Another important focus is how far out in time should you sell your covered call? I usually say for my timeframe it makes sense to look at 30-45 days to expiration (DTE) since they have the sharpest theta decay acceleration and that helps a short option decline in value faster once you are inside 30 DTE. However, depending on the stock you are using and what the current overall market implied volatility is, it can be beneficial to go as far out in time as the next earnings announcement. This assumes you are a long term investor and want to take in as much covered call premium as possible each quarter. The amount of premium in expirations that involve an earnings report are often far greater because the “unknown” factor is large and stocks tend to make their largest percentage moves each quarter on their earnings reports. Many funds focus on selling options further out in time for this reason. If they are holding or willing to hold stock into the future then selling a 3 month or 6 month option is just fine in order to collect the most premium for a covered call. 

Covered Calls as Part of a Wheel Strategy

A Lot of options traders like to use the “wheel strategy” which is simply selling a cash secured put to get long stock if the shares are put to them, then selling a covered call on the shares they were assigned from selling the put. There is nothing wrong with this idea and overall I think it’s a great way to use options and learn about how they work. The interesting thing about this strategy is that if the call you sell each week/month expires worthless each cycle, the trader can just re-sell a new covered call in a new expiration cycle. Collect more premium each time and continue reducing the cost basis on the stock holding if they want to own it. Sort of like owning a rental property and collecting monthly rent income on it. This is a great way to participate in options trading without staring at the screen all day also. Since a covered call against long stock requires no additional buying power it’s often a no brainer to sell covered calls against your holdings. But be sure you want to own the stock and are not just holding stock to collect a small premium each month because holding 100 shares of any stock is still a capital commitment. This is also best done using value stocks compared to growth stocks. Even though growth stocks will almost always have higher option premiums to sell covered calls on, they are also more volatile for a reason. As we have seen during late 2021 and early 2022, a growth stock can go much lower than the market imagines. 

Takeaways:

  • Covered calls have no upside risk because they are covered by 100 long shares of stock.
  • Covered calls can be used in IRA accounts to enhance returns.
  • Covered calls have risk to the downside since the strategy is long 100 shares for each call sold but those shares are not fully hedged.
  • In theory, a covered call investor can continually sell calls against stock holdings and never be called away if they roll and adjust to the further expiration in enough time.
  • The strike price and expiration you determine to use should be based on your goals and overall market assumptions.