Covered Call Writing

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 | Diagonal Spread
Covered Call Writing

Learn how to set up and profit from diagonal calendar spreads

A diagonal calendar spread is a combination of a calendar spread ( also known as a horizontal spread ) with a features of a vertical debit spread.

The strategy is similar in principle to a vertical debit spread where the underlying presumption is bullish but you want to fund your bull call by selling a call for premium.  By doing so, however, you will be capping your maximum profit but also limiting your risk 

Just as in a typical vertical debit spread that this strategy mimics, the diagonal calendar spread can be set up to be bullish using calls or bearish using puts.

 

Learn How To Adjust Calendar Calls

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.

A bullish long call diagonal spread is set up by

  • Buy a distant month ITM call at a lower strike price
  • Sell a proximate month OTM call at a higher strike price
  • total debit paid should be no more than 75% of the strike width
  • The intrinsic value of the long strike should approximate the short strike.

You will want to set this trade up in a low volatility environment but with a bullish direction.  

A Long Call Diagonal Spread is constructed by purchasing a call far out in time, and selling a near term call on a further OTM strike to reduce cost basis. This trade is set up as a debit.

This option is typically closed when the short option expires. However, it is also common close the short option only to sell another short option for more premium either at the same strike price.

The setup of a diagonal spread is very important. If we have a bad setup, we can actually set ourselves up to lose money if the trade moves in our direction too fast. 

To ensure we have a good setup, we check the extrinsic value of our longer dated ITM option. Once we figure that value, we ensure that the near term option we sell is equal to or greater than that amount. 

The deeper ITM our long option is, the easier this setup is to obtain. We also ensure that the total debit paid is not more than 75% of the width of the strikes.

 

We never route diagonal spreads in volatility instruments. Each expiration acts as its own underlying, so our max loss is not defined.

 

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 )

Option Basics

Buying a Call

Profit and Loss Chart

  • Max Profit Potential: (Short Call Strike + Credit Received for Call – Share Purchase Price) x 100
  • Max Loss Potential: (Share Purchase Price – Credit Received for Call) x 100
  • Expiration Breakeven: Share Purchase Price – Credit Received for Call
  • Approximate Probability of Profit: Greater than 50%
 

Buying a Call

Assignment Risk

If assigned on the short 80 call, then the covered call writer is obligated to sell 100 shares of stock at the strike price. Since the trader already owns 100 shares, the assignment leaves the trader with no position. However, the bright side is that a being assigned results in maximum profit for the covered call writer.

As you can see, buying 100 shares of stock at $75 and selling the 80 call for $3 reduces the risk of the position compared to just buying and holding stock. Since a credit is collected for selling the call, the purchase price of the shares is effectively reduced by the amount of the call price. Therefore, the breakeven price of a covered call position is essentially the reduced purchase price of the shares. However, for this purchase price reduction, the position’s potential profits are capped when the stock price rises above the strike price of the short call.
 
We’ve also added the profits and losses for a long stock position as a comparison. Compared to the long stock position, the covered call has less loss potential and more profit potential at most of the prices. However, if the stock price rises significantly above the short call strike, then the long stock position without a short call against it performs better. Because of this, a covered call writer is usually not extremely bullish on the stock.

You know the potential outcomes of a covered call position at expiration, but what about before expiration? As a demonstration, we’re going to look at a few positions that recently traded in the market.As you can see, buying 100 shares of stock at $75 and selling the 80 call for $3 reduces the risk of the position compared to just buying and holding stock. Since a credit is collected for selling the call, the purchase price of the shares is effectively reduced by the amount of the call price. Therefore, the breakeven price of a covered call position is essentially the reduced purchase price of the shares. However, for this purchase price reduction, the position’s potential profits are capped when the stock price rises above the strike price of the short call.
 We’ve also added the profits and losses for a long stock position as a comparison. Compared to the long stock position, the covered call has less loss potential and more profit potential at most of the prices. However, if the stock price rises significantly above the short call strike, then the long stock position without a short call against it performs better. Because of this, a covered call writer is usually not extremely bullish on the stock.

Buying a Call

Covered Call vs Holding Shares

First, let’s examine a situation where covered call writing is less lucrative than just buying and holding shares of stock. Here’s the setup:
 
Initial Share Purchase Price: $121.45
 
Strike Price and Expiration: Short 125 call expiring in 74 days
 
125 Call Sale Price: $1.41
 
Breakeven Stock Price (Effective Share Purchase Price):
 
$121.45 share purchase price – $1.41 credit received from call = $120.04
 
Maximum Profit Potential:
 
($125 short call strike – $120.04 effective share purchase price) x 100 = $496
 
Maximum Loss Potential:
 
$120.04 effective share purchase price x 100 = $12,004 (stock price goes to $0)
 
Purchasing 100 shares of stock for $121.45 per share and selling one of the 125 calls for $1.41 results in a breakeven price of $120.04. Because of this, the stock price can fall, and the covered call can still profit. However, for that protection, the profit on the long shares is capped. At expiration, any stock price above the short call strike of $125 will result in the same gain for the covered call writer.
 
With that said, let’s see what happens!
 
Covered call writing example trade.
As illustrated here, the stock price rising above $132.50 results in profits of $1,250 for an investor who just bought and held 100 shares of stock.
 
On the other hand, the profit potential is limited for an investor who sold the 125 call against their shares. It doesn’t matter if the stock price is $125 or $1,000 at expiration, the profit on a covered call position with a short 125 call will be the same.
 
So, by selling a call against shares of stock, an investor gains the ability to profit when the stock stays flat or declines slightly. However, that benefit comes at the cost of profit potential on the long shares.
 
In this example, the maximum profit potential is achieved fairly early in the trade because the stock price traded significantly higher than the short call strike price. When maximum profit is achieved before expiration, it’s likely that the trader will close the position to lock in the profits. To close a covered call position, the trader can simultaneously sell the shares of stock and buy back the short call. 
 
After expiration, this particular covered call writer would lose their shares if they held the short 125 call through expiration. To keep the shares, the investor would have to buy back the 125 short call at a loss, though the overall covered call position was profitable. Lastly, it’s important to note that the trader in this scenario faces an early assignment on the short call because the option is deep-in-the-money for most of the trade.
 
Next, we’ll look at an example of when covered call writing works out perfectly.
 

Covered Calls

Income Generation Using Covered Calls

In the next example, we’ll look at a situation where the stock price remains in a particular range over 53 days. More specifically, the stock price is the same at the beginning and the end of the period. Over this time frame, we’ll compare a covered call position to a long stock position.
 
Here’s the setup:
 
Initial Share Purchase Price: $116.45
 
Strikes and Expiration: Short 120 call expiring in 53 days
 
120 Call Sale Price: $5.80
 
Breakeven Stock Price (Effective Share Purchase Price):
 
$116.45 share purchase price – $5.80 credit received from call = $110.65
 
Maximum Profit Potential:
 
($120 short call strike – $110.65 effective share purchase price) x 100 = $935
 
Maximum Loss Potential:
 
$110.65 effective share purchase price x 100 = $11,065 (stock price goes to $0)
 
This time around, we’re examining a covered call position where 100 shares of stock are purchased for $116.45 per share, and the 120 call is sold for $5.80. The breakeven price in this case is $110.65, which means the stock can fall $5.80 and the covered call writer will not lose money.
 
Let’s take a look at what happens:
 
Covered call writing example trade.
The first thing to note about this trade is that the covered call position performs better than a long stock position when the shares remain below the short call’s strike price. This is because the profits from the short call offset losses (or add profits) when the stock price is below the short call’s strike price.
 
The second thing to note is that after expiration, this particular covered call writer would keep all the premium from selling the call, as the 120 call expires worthless. Since the 120 call was sold for $5.80, the covered call writer realizes a $580 profit when the call expires worthless (out-of-the-money). Additionally, when the short call expires out-of-the-money, a covered call writer keeps their long shares.
 
Lastly, you’ll notice that the long stock investor broke even on their position, as the stock price was the same at the beginning and the end of the period. However, the covered call writer made $580 from the premium collected on the call option. So, selling calls against long stock can be highly lucrative in a period of range-bound stock prices.
 
In the final example, we’ll look at a covered call position that is defensive in nature. While not profitable, we’ll see how the covered call compares to a long stock position.
 

Buying a Call

A Defensive Covered Call

Covered call writing provides protection against declines in the stock price. Because of this, covered calls can be used defensively. So, in the final example, we’ll look at a scenario where a covered call position is unprofitable but better off than just buying and holding stock.

 

Here are the specifics of the final example:

 

  • Initial Share Purchase Price: $119.99
  • Strikes and Expiration: Short 120 call expiring in 37 days
  • 120 Call Sale Price: $2.58
  • Breakeven Stock Price (Effective Share Purchase Price):
  • $119.99 share purchase price – $2.58 credit received from call = $117.41
  • Maximum Profit Potential:
  • ($120 short call strike – $117.41 effective share purchase price) x 100 = $259
  • Maximum Loss Potential:
  • $117.41 effective share purchase price x 100 = $11,741 (stock price goes to $0)

 

Covered call example trade.

In this particular trade, the stock price fell sharply, resulting in losses for the covered call writer and the long stock investor. However, since the covered call writer collected $2.58 in premium, their loss was $258 less than the long stock investor at the expiration of the short call, demonstrating how a covered call can be used defensively.

Buying a Call

How To Choose the Strike Prices for a Covered Call

In order to better understand how the covered call strategy has performed over time, tastytrade designed and conducted a study that segmented the results by call delta.

 

Delta is, of course, the Greek that tells us how much an option’s price will change for every $1 move in the underlying. So at-the-money options, which are more sensitive to underlying price movement, have higher deltas, while out-of-the-money (OTM) options have lower deltas.

 

In terms of strike selection, that means that traders selling ATM covered calls would be selling approximately 50 delta calls. From there, going higher on the strike ladder (further out-of-the-money), reduces the delta.

 

In the study, tastytrade analyzed 50 delta, 30 delta, 16 delta, and 5 delta covered calls to provide a snapshot of the relative performance of covered calls across the delta spectrum. The study used data from 2005 to present and evaluated options with an average duration of 45 days-to-expiration.

 

The graphic below highlights the results of this study:

 

covered calls

As you can see from the above, the data indicates several important trends.

 

First, the ATM covered call strategy does not produce as high returns as the other delta levels (on average). Additionally, the 50 delta strategy also missed out on profits the highest percentage of the time (43.96%).

 

On the other hand, the 16 delta strategy returned the highest average P/L, while missing out on profits only 14.88% of the time.

 

The results above obviously take into account a broad range of market conditions. Therefore, traders with no opinion on the direction of the markets may lean toward selling lower delta covered calls, such as the 16 delta category illustrated in the graphic above.

 

However, it’s certainly possible that traders may also align their covered call strategy with their view on market direction, which may call for a different choice in strike selection. Obviously, in bear markets, the relative performance of higher delta covered calls will improve.At this point, you know how covered calls work, as well as when you might use the strategy. However, with so many different call strikes available, how do you choose which one to sell? We’ve put together a simple guide that may help the strike price selection process easier.

 

Strike Price Selection: Determine Your Stock Price Outlook

Before selecting a call strike to sell, it’s crucial to determine an outlook for the shares of stock that you own. Here is a quick guide that demonstrates how to select a call strike based on various outlooks:

 

You Believe the Share Price Will Increase Significantly:

 

With such a bullish outlook, selling calls to limit the profit potential on the long shares might not make sense. Additionally, selling far-out-of-the-money calls doesn’t provide much profit potential or downside protection since far-out-of-the-money options are cheap.

 

You Believe the Share Price Will Increase Moderately:

 

Selling a call option with a delta between 0.20 – 0.30 may be logical, as those options only have a 20-30% probability of being in-the-money at expiration (in theory).

 

You Believe the Share Price Will Remain Flat/Decrease Slightly:

 

With a neutral outlook, selling calls with strike prices closer to the stock price (.40 to .50 delta calls) may be logical. Selling at-the-money calls provides the greatest profit potential from the decay of the call’s extrinsic value.

 

You Believe the Share Price Will Fall:

 

With such a bearish outlook, owning shares of stock or trading covered calls is likely not the appropriate strategy.

 

The table above serves as a guideline for selecting a call to sell. When trading covered calls, there isn’t a “one-size-fits-all” approach. The call that is sold depends on the investor’s outlook for the stock price in the future.

 

Awesome! You’ve reached the end of the guide. Hopefully, you’re much more confident in your understanding of the covered call options strategy.

Option Basics

How Do Covered Calls Change with Volatility and Time

A call option will benefit from :

  • A rise in stock prices
  • A rise in volatility
  • An early rise in stock price ( time kills the stock value )
  •  Positive Delta – Call prices rise when the stock price increases, which benefits the call buyer. Conversely, call prices fall when the stock price decreases, which is not good for the call buyer.
  • Positive Gamma – A long call’s position delta gets closer to +100 as the stock price increases and closer to 0 as the stock price decreases.
  • Negative Theta – The extrinsic value of options decays as time passes, which is detrimental to a call buyer
  • Positive Vega – An increase in volatility will increase the value of a call option ( indicated by positive vega ).  Conversely, a decrease in volatility will decrease the value of a call option ( indicated by a negative vega 

Buying a Call

Management and Adjustments

  • Maximum Profit Potential: Unlimited
  • Maximum Loss Potential: Premium Paid for the Call
  • Expiration Breakeven Price: Call Strike + Premium Paid for Call
  • Estimated Probability of Profit: Less Than 50%
  • Assignment Risk?

Option Basics

Tips and Tricks

A call option will benefit from :

  • A rise in stock prices
  • A rise in volatility
  • An early rise in stock price ( time kills the stock value )

Buying ITM -in the money call options will

  • Increase the amount of directional exposure since in the money options have deltas closer to +1
  • ITM options are less affected by theta decay

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