The Covered Call is a great bullish strategy with the same risk profile as a Short Put. It’s suitable for beginners and pros alike. I’d say probably one of the easiest ways to get into options trading if you own 100 shares of suitable stock.
You may ask why don’t I just sell a put instead? Well, you may be starting out and feel more comfortable with shares or you have the stock already and don’t want to risk being assigned more of it.
This strategy is set-up by sending a buy order for 100 shares, unless you have them, and a sell order for 1 call option at your chosen strike.
Covered Call Delta
One interesting fact about the Covered Call is that it combines static and dynamic Delta. Each share has 1 Delta, which doesn’t change under any circumstances unlike the option Delta.
Choice of Strike
The short call option Delta will depend on your choice of strike. Nevertheless, it is preferable to collect as much premium as you can. Having said that, you also don’t want to be too close to the money if you want to capture an up-move.
Let’s have a look at an example with our theoretical $50 stock.
100 shares x $50 and -1 $50 Strike call (54 Delta) option x100 x $3.70
The max profit is the $370 you collected for the option, while the max loss is $5,000 – $370 = $4,630 should the company go bankrupt.
The positive side is that if the stock trades for $49.99 at expiration you’ll make $3.69 per share without the stock ever moving! Therefore, the breakeven share price of this strategy is $46.30.
If we assume constant volatility, a 35 day call and the stock going up to $57 around 20 days prior to expiration your theoretical P&L will look like this:
100 shares x $50 and -1 $55 Strike call (34 Delta) option x100 x $1.89
This time the max profit is ($55 – $50) x 100 from the shares plus $189 from the options giving you a total of $689. You’ll buy the shares for $50 and then sell them for $55 once the call is exercised.
The max loss is $5,000 – $189 = $4,811 which matches a breakeven share price of $48.11. If the stock trades between $50 and $55 the call will expire worthless, you’ll collect $189 and keep the shares. It’s an excellent way to reduce the cost basis of your shares.
You may have heard of dollar cost averaging. This is exactly the same thing only that you use options, e.g. other people’s money not yours.
The disadvantage is that the outcome of the covered call is unpredictable to an extent but so is dollar cost averaging. One certain thing is that there will be uncertainty either way.
We never get any free lunch in the market and you can see that scenario 2 is more profitable on the upside. However, you risk more capital because of the higher breakeven price.
Here is the theoretical P&L using the same assumptions as above:
Note that the max profit in Scenario 2 is dependent on appreciation of the stock’s price to $55 or beyond. Therefore, you can tweak your strike based on your directional assumption whenever you set up a covered call.
Directional assumptions matter
If you are bullish you can sell a 20 Delta call, while if you already own the stock and you believe it is on a downtrend you can sell the at the money option, usually around 50 Delta. The former will give you a higher max profit and an increased probability that the option will expire worthless. While the latter will let you collect more premium at a higher risk of losing the shares and lower max profit.
One fascinating thing about options is that sometimes it’s difficult to label a strategy bullish or bearish. The covered call is in the bullish category but you can see that it can be used as a slightly bearish strategy too. The latter is a good way to preserve your capital if you anticipate a decline in the stock value.
You may have owned the shares for some time and you want to sell them for an arbitrary price of $53 for example. Then you just sell the $53 call and wait to see if the shares will be assigned. If they don’t you can repeat this until you succeed or collect enough premium to meet your price target.
A call option normally has positive Delta, however, you are selling it so your Delta will be negative. Instead of going up to 100 as the share price increases it will go down to -100.
You already have 100 Delta from the stock so if you sell the 34 Delta call you get 100 x (-1 x 34) = 66 Delta. The option from Scenario 2 has a Gamma of 4 which means that if the share price increases to $52 your position Delta will decrease to 66 – (4 x 2) = 58.
The Covered Call doesn’t have any significant Gamma implications to worry about. Yes, you are short Gamma, however, the option is covered so the worst that can happen on the upside is for you to realise the strategy’s max profit.
This can be a problem only if you were selling options to make some extra money from the stock. You’ll lose your shares should the call be exercised.
Covered Call Theta and Vega
You want to sell the call when the implied volatility (IV) is high. This time it’s not so much to justify the risk but to get the best value for money. Whether you want to sell your shares or you just bought them and want to reduce their cost basis the more premium you collect the better.
If the IV is high the option’s price and Theta are high too. You collect time value while waiting for the IV to decrease. It’s not a bad set-up because IV normally decreases during an up-move and you profit from Vega while waiting to see if you’ll get your max profit.
There’s not much to manage in terms of winners, the shares are called away and you get paid. If you changed your mind about losing the shares you can roll the call for credit in the next expiration cycle. Maybe the underlying’s price will stabilise below your strike and you’ll pick up the option premium.
Beware that when you roll you close one options position and open another. This means that you will realise a loss when the call has increased in value. For example, you sold a call for $1.00 and you buy it back for $1.50 so you lose $50. Now you need to make at least $0.50 from the new position just to break even.
It’s a bit like dollar cost averaging when the share price is tanking. You’ll need an infinite amount of money and shares to average it down to $0.01 per share from say $50. This strategy will inevitably fail and accrue a massive loss should the price go to $0.00. Even an infinite amount of money can’t save it.
Losers from a covered call occur when the share price drops because you lose money on the stock. You can manage this by rolling the call to a lower strike. This time you realise a profit when you roll. For example, you sold the call for $1.00 and you buy it back for $0.50 so you earn $50. Then you sell a lower strike call for $0.70 and wait.
Covered call for income
Another management option is to close the position when you realise 50-75% of the max profit of the call option. You sold the call for $1, the price goes down to $0.50, you buy it back to realise $50 profit then sell the next cycle, rinse and repeat.
Both the share price and the option’s price will fluctuate through the life of the trade. This presents you the opportunity to close the position early and realise some of the profit.
Then you just wait to see if the call options prices will increase as the share price rebounds. You can sell the same call again, choose a different strike or the next cycle.
An ideal situation would be if the call in scenario 2 loses half of its value and you close your position only to see the share price rebound to $57 for example. You will realise a profit of $7 per share + ($1.89 / 2) = $7.945 or $794.5 in total should you choose to liquidate the whole position.
Unfortunately such occurrences are difficult to predict and results will inevitably vary from one trade to another.
Regret & Hindsight Trading
Sometimes you’ll set-up a Covered Call, the strike will be breached and the share price will keep going up. Sure, you’ll make money but you could have made more.
That’s when regret starts to creep in. You may feel down or keep questioning your decisions. It’s not a great feeling.
I am against hindsight trading. There was a reason why you set-up the Covered Call and it was valid for you at the time of trading. You couldn’t have known how events will unfold.
This is important to remember in cases when new information comes out. Could you have predicted it? Probably not so why do you feel regret over this?
Trading opportunities emerge on a daily basis, this position has been closed and now you can move on to other things. You made money, didn’t lose it so why the long face?