Covered Calls

Learn how to use covered calls to reduce the price of buying a call or to hedge for the downside potential of your existing stocks.

Bullish Option | Hedge Strategy
Covered Calls

Learn how to set up and profit from Covered Call Options

If you have a 10 strike wide 95-105 call debit spread and the stock price is 100 ( in the middle ) 

The two most important reasons for setting up a covered call:

  • Reduce cost basis of buying a stock
  • Hedge an existing stock portfolio if you already own 100 shares of a stock.
  • Covered calls are profitable even if the stock down’t move
Covered calls are profitable unless the stock moves down below the break even price.  

A covered call reduces the cost basis of buying a stock by accepting a premium for selling a put above the stock price.  
 

If you were to sell the 105 put for a premium of 5 dollars.  The collected premium effectively lowers the cost basis of buying 100 shares of the stock at 100 dollars to buying the 100 dollars of shares at 95 dollars.  The break even price is now 95 dollars.

In order to set up a covered call, you must own 100 shares of stock.  If you don’t already own 100 shares of stock, you can buy a call option to make the purchase

You will then sell and OTM out of the money put to reduce the cost basis and hedge the outcome of the stock purchase.  

 

  • Buy or own 100 shares ATM
  • Sell OTM call to collect premium

 

The max profit is obtained anywhere above the short strike at expiration.  ( above  105 ) = spread width + premium = 15

The best stock movement scenario = ( believe it or not ) is for the stock to move in your favor and blow by above your short strike.  

The short strike would lose all of its value, but this is offset by the profit of the ITM in the money long options.  You would collect the maximum profit of the ( strike width + the premium received ) or 10+5 = 15.

You would only manage a covered call if the stock price completely goes against you and is below the break even price.  

Recall that a covered is profitable if either the stock price stays the same, moves between the strikes, or even it it moves above the short strike ( this is actually the best scenario )

If the stock moves in your favor and moves above the short strike, you will achieve maximum profit.  The maximum profit is calculated by the width of the strikes minus the debit you paid.

In this example, the width is 10 and the debit it 5.  So if the price goes above the short strike, you will collect a 5 dollar ( 10-5=5 ) profit.

If the stock moves against you and moves below the long strike, you will achieve maximum loss unless you adjust or manage your trade.  Maximum loss is simply the price of your debit premium.  In this case it is 5 dollars.

You will want to manage this trade by rolling the short strike down toward the long strike, while also narrowing the width of the spread.  

Rolling the short strike should gain you a credit ( lets say .30 cents ) while also narrowing the width of the spread.  This adjustment will lower the cost basis even if you continue to expect to lose money on the trade.

If the original debit was 5 dollars and you were able to get another 30 cents.  Then even if you still lose in the trade, your loss has decreased from 5 dollars to 4.7 dollars.

If the stock price now manages to rally ( before expiration ) and rally back above the short strike, you will now be profitable albeit a lesser profit than originally designed.  Remember that you managed this trade by bringing down the short strike and narrowing the strike width to 5 points wide.  Your profit is based now on a strike width of 5 minus the debit which is now 4.7.

 

If the stock price does not move at all, the short strike will expire worthless and you would keep the premium.

The long call is simply the change in the value of the stock, which in this case has not changed.

So the value of the option is the profit of the premium that was sold.  5 dollars.

Note that you can manage this trade by moving the short strike ( for a profit ) toward the stock price if you can get a credit and you remain bullish on the trade.  

A covered call reduces the cost basis of buying a stock by accepting a premium for selling a put above the stock price.  

If you were to sell the 105 put for a premium of 5 dollars.  The collected premium effectively lowers the cost basis of buying 100 shares of the stock at 100 dollars to buying the 100 dollars of shares at 95 dollars.  The break even price is now 95 dollars.

A covered call reduces the cost risk of buying a stock by accepting a premium for selling a put above the stock price.  

If you were to sell the 105 put for a premium of 5 dollars.  The collected premium effectively lowers.  The break even price is now 95 dollars. The stock can now drop by 5 dollars and you still would not have lost any money.  

If you already own 100 shares of the stock, the covered call strategy protects you by lowering your break even price.  In this case, by 5 dollars.

Bringing down the short call strike toward the stock price will decrease the cost basis of the option even further.

You will receive more premium as you move closer to ATM and ITM options.  

The maximum profit, however, is reduced because the spread with is also reduced BUT this might not be a bad thing if a stock is already at a short term peak such as an all time high where you want to hedge to the downside.  Recall that the break even price of the option has also been lowered by accepting more premium.

 

See above explanation for how does reducing the spread width affect a covered call.

  • Reduces the cost basis
  • More downside protection by decreasing the break even price.

 

Introduction

Same risk profile as a short put

Use to reduce the cost basis if you want to purchase a stock by selling a put against the purchase

You need to think of this in contrast to buying a stock outright

 

 

Setting Up a Covered Call

FYI- Would rather use strategies that sell premium rather than using debit spreads

Set up in low volatility environments

Straddle the stock price

Buy an ITM option and Sell an equidistant or slightly closer OTM option

Set up so that the break even is just around the stock price or ideally even just a little bit better

Debit spreads reduce the cost basis of the long option- caps the upside but reduces the max loss increasing your probability of success



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