Covered calls are considered one of the safest plays in the stock market, and I am willing to bet that you have never even heard of them.
So lets start with the extreme basics of options. You don’t really need to be an expert on delta and theta and all of the scary weird things about options to successfully trade a covered call, but you do need to know the basics of what an option even is.
What is a Call? It’s an option contract. Well what’s an option contract? An option contract is a contract that gives you the option, or right, to purchase 100 shares of a stock at a specific price (called a strike price) by a specific date (Expiration date). A “Call” is making the bet that you think the price of the underlying stock will increase, while a “Put” is a bet that you think the price of the underlying stock is going to decrease. Well what does that even mean?? Lets look at it shall we.
First lets get a basic understanding of options.
Lets use SPY as a quick example. As of writing this, its current price is $415. Lets say you think the price is going to go up. You can by a Call option for a strike price that you select. You can choose ITM (in the money) or OTM (out of the money). An ITM price would be something like $400, because its cheaper than the current $415 price, while an OTM call would be something like $420, because its higher than the current $415 price. In the money, below the current price. Out of the money, above the current price. Makes sense right?
Well why would you ever buy the OTM calls? Wouldn’t you just want to buy a call that is already below the current price to make money? Well the MMs are on to your sneaky games and understand that. ITM calls are more expensive than OTM calls. If you select a $400 Call when the price is at $415, then you have to pay for that $15 of profit that’s already baked in. Vice versa, if you buy a $420 call, the price is much cheaper, because, technically, your option contract is worthless unless the price of that stock gets above $420. Remember if that option contract has a $420 strike price, you are committing to purchasing SPY for $420 before the expiration date of the contract. If the price is NOT above $420 by the selected date, it becomes worthless.
So remember in basic context, when you BUY an option call, you are basically saying “I want to buy SPY for a specific price, before a certain date.” The price of the option may vary by how far out the expiration date is, and how far ITM or OTM you are. Example, a Call that expires two years from now that is currently in the money, will be way more expensive than an out of the money call that expires next week. The higher the probability that you get to use that option, (Its called exercising when you actually use the contract) the more expensive it is. That’s what Delta tells you, but I said I wouldn’t get into that, so moving on!
Ok so now we have a basic understanding of what a Call is. Lets talk about covered Calls. That’s why were here anyways. The good stuff.
In our new scenario, lets say you own 1,000 shares of SPY, and you’re letting them ride the wave of the market for the next few months. You can get paid to SELL a Call against your shares. You read that right. Paid to sell a Call. Remember, when someone “buys” a SPY Call, they are committing to buying shares of SPY at a specific price. When you SELL a Call, while owning said shares, you are giving someone the right to buy YOUR shares.
Well now wait. Cardinal, why would I want to sell my shares? What price? When? This is odd.. Right right right relax. Remember, you are the one selling the Call. You pick the price. You pick the expiration. You get paid to do it. Lets see it in action and see how it plays out.
The snip above shows the available Calls for SPY. Looks complicated doesn’t it? Don’t be afraid, you got this. The only three things you need to know are the Bid price, the Expiration, and the Strike price. Ignore everything else. The bid price is what you will be paid for each contract you sell, the expiration is when it expires (duh) and the strike is the price that you would be selling your shares for.
In our scenario, you are swinging your shares. You are planning on keeping them no matter what, because you expect that in the next few months you’re going to make a profit. If it goes down a little, you’ll keep it, if it goes up a little, you’ll keep it, but if it spikes you’d happily sell it. That’s the idea of a typical swing right? So if you’re holding your shares, lets get paid to do it.
The first thing you have to decide is what price you would be happy selling your shares. Lets go with $425. That would be a nice $10 gain from the $415 on your 1,000 shares. The current Bid price for the $425 option is $1.95.
The next thing you have to decide, is how long you want to hold your shares. Remember, the longer out you go, the more you get for your contracts. (Longer out means a higher probability of hitting the strike price.) July 16 is the only one snipped, so that’s what were using. Some options go out years from the current date. For instance, the Bid price on a SPY Call dated for Dec 15th of 2023 is $39.37. Big difference from the $1.95. That’s because the probability of SPY reaching $425 from the current $415 price in two years is extremely high.
Once you have narrowed those two down. Lets make the order.
You would SELL 10 16 July 21 $425 contracts. 10 contracts, because we already own 1,000 shares. Each contract represents 100 shares.
You would get paid $1,950 (excluding any broker fees, TD is $6.50 in this example) from selling our contracts.
$1,950 for doing nothing but holding the shares we were already planning on holding.
The scenarios:
Lets say that on July 16 the price of SPY is $423. You still own your 1000 shares, AND you keep the $1,950, because that $425 option you sold expired worthless to the poor person that bought it. Win win win.
Lets say that on July 16 the price of SPY is $427. Your shares will be sold for $425, and you keep the $1,950, BUT you also keep the profit from your shares because you owned them at $415. So you made $10 per share in profit ($415 up to $425), AND you keep the premium of $1,950 for selling the calls. Win win.
Lets say that on July 16th the price of SPY dropped to $410. You keep your 1000 shares because it didn’t reach the $425 strike price, AND you keep the $1950 premium. You have a loss on your 1,000 shares, because the price went down. BUT you were going to hold the shares anyway right? You would have taken that loss anyway, but now you at least have that $1950 premium to soften the loss.
The only times this doesn’t sit well is if something crazy happens.
Lets say you’re doing covered calls on a different company, not an index. If that company goes bankrupt or something crazy bad happens, your shares are going to take a beating. BUT good news. While your shares took a beating, you still keep that premium.
The last annoyance is if something crazy good happens. Lets say you own shares at $10 and have a strike price of $15 and the stock shoots to $30. Well, you’re stuck selling your shares for $15 and miss out on the profit from $15 to $30. You still keep the premium and the profit from $10 - $15, but miss out on that juice from $15 to $30. But don’t get fomo. You probably would have sold at $15 anyways and missed out. Lets be honest. Unless you are the HODL type.
Remember to try and put your orders in on green days or spikes upwards during the day. You’ll want to get the highest premium you can.
Pro tip: Don’t just use the Bid price. If the Bid is $1.00 and the Ask is $1.50, put your order in at $1.25 and let a MM fill your order. Note that this doesn’t always work, and volume on the call will make a difference.
Also NEVER do a covered call with an ITM call below your owned price. You will lose real money on this because you are choosing a strike less than the current price. Always do OTM calls. That way you are always selling your shares for a profit from the day you sell the call.
NEVER sell calls unless you own the underlying stock. That is called a naked call or short. That’s how things like GME happened. People were forced to buy more and more shares because they didn’t already own them.
Play around with some of the stocks you currently plan on holding and see what premiums you can find. Stocks that have weekly options available mean you can do this every week.
As always, this is just another tool in your belt and should be combined with all of the other things you know and have learned. Find your niche and make some money.
I hope this helps! Feel free to reach out to me if something doesn’t make sense or I missed something. Twitter -> @CardinalTrades