A Covered Call strategy is one of the most popular for investors that own stock. A call option is sold short against a shares already held. It is an excellent strategy for mildly bullish traders who want to use options to generate extra yields.
However the subtle twist to a covered call strategy is that it is exactly the same as selling short naked puts. The pay-off and risks are the same for both strategies. Think about it.
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Covered Call
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| Risk: |
Limited |
| Reward: |
Limited |
| The Trade: |
Buy shares short (usually) an out of the money Call option |
ABC Stock trading at £5.00
Buy 1,000 ABC shares at £5.00, sell short 1 Sep £6.00 call (see pay-off diagram below)
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| When to use: |
You are mildly bullish or neutral towards a stock. The perfect result for this type of strategy is when the stock rises to the short call strike on expiration. If you bought the stock at £5.00, sold the £6.00 call short and on expiry the stock was at £6.00 you'd collect the entire premium from the option that expired worthless and keep the stock.
Then if you choose repeat the process by selling another call.
Trading a covered call strategy also enables a trader to make a return in a flat market. If you bought the stock at £5.00, sold the £6.00 call and the stock was still around £5.00 on the expiry date, the short option would expire worthless so giving you a nice profit on the deal.
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| Volatility expectation: |
Volatility neutral to lower |
| Profit: |
Limited to the difference between the price where the stock was purchased and the short call option combined with the premium received from the short call. |
| Loss: |
Limited because the stock can't go below zero. Also if the stock rises considerably then the loss on the short call will be offset by the profit gained on the long stock. |
| Breakeven: |
Reached if the stock falls below the purchase price plus the option premium received. |
| Time decay: |
Time decay will help |
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Trading ideas and tactics:
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- Consider 'legging' into them, buying the stock and selling the call on a rally in the stock price, therefore selling calls at a higher price and receiving more premium
- Best to trade in slow upward trending markets
- It's a bullish/neutral trade so can't really make money in a falling market. If prices do decline then the covered call writer will just lose slightly less than the holder of stock (who doesn't sell calls) because he picks up the premium from the short options which expire worthless
- Because you are collecting time value on the short options you want to try and sell calls that have at least 3 months and preferably 6 months to expiry
- Use charts to determine good levels to sell calls against
- Using a short straddle is often a more conservative way of using trading covered calls. Instead of buying 2000 shares and selling 2 call options, purchase 1000 shares and sell an out of the money strangle, see short strangle
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