Covered Calls Strategy 8, Covered Calls Strategy

The covered calls strategy has been used by conservative investors for decades. In exchange for giving up some upside potential the investor receives some downside protection. At option expiration if the stock has stayed flat or gone up then income has been generated. It's even possible to generate income if the stock goes down a little, which is why this is a popular strategy.

Among option-based strategies, the covered calls strategy is the easiest to grasp, the most popular, and the most conservative. It is also the one that most investors learn about first when starting to invest with options.

How The Strategy Works

  1. You need to own 100 shares of stock or an ETF.
  2. You then sell one call option (because each option controls 100 shares) against the stock/ETF you own.
  3. When the option expires you may end up having your stock called away (and receive cash) or you could end up owning your stock and having the call option expire worthless (in which case you can sell another call for the next cycle).

For more details and example trades, see our full covered call tutorial.

How Call Options Work

A "call option" has an expiration date and a strike price. It is one half of a covered call trade (the other half is the stock you own). It gives the buyer of the option the right to buy 100 shares of stock at a certain price (the strike price) on or before a certain date (the expiration date). It also obligates the seller of the call option to deliver 100 shares of stock when requested by the buyer if they are exercising their option.

You can choose whichever strike and expiration you want. For example, if you owned 100 shares of ABC that was currently trading at $35/share, and if you would be happy selling that stock at $40/share next month then you would sell 1 call option with a strike of 40 that expires next month. You would receive some cash today in exchange for selling the call option.

On expiration day if ABC is less than 40 then you keep the stock and the money you got from selling the call. If ABC is over 40 then you will lose your stock but you will receive $40/share of cash in its place (plus the money you got from selling the call in the beginning). You can then use all that cash to go buy more stock (maybe a different stock, maybe the same stock) and repeat the cycle.

You can make money with the covered call strategy even if the stock goes down.

This is the part that most people find interesting. Let's look at a real-world example.

Today you can buy ATPG for $16.20. You need 100 shares, so that's $1620. After that you can sell one Dec 15 call option for $1.88 (strike of 15, expiration date of Dec 18, 2010). You will receive $188 today.

At this point your break-even is 14.32 (16.20 - 1.88). If ATPG were to close above your break-even point on Dec 17 (last day the Dec options trade before they expire) then you have made money. That means the stock could drop $1.87 (11.5%) between now and Dec 17 and you would still make a profit -- that's why people like this strategy. If the stock drops 10% in 40 days you've still made a profit... because you sold an in the money call option.

If ATPG closes above the strike price (15) on Dec 17 then you will receive $1500 for your 100 shares when the option is assigned to you. Remember, at the start you paid 1620 but you received 188 so your net debit was $1432. So you made (1500 - 1432), or $68, on an investment of $1432. That's 4.7% in 40 days, or 42.9% annualized. Nice!

Get Rich Slowly

The covered call strategy is not get-rick-quick, and shouldn't be thought of as such. But it can produce profits on a regular basis. You'll want to have multiple positions in several different sectors for diversification. If you have a small account then consider ETFs since they have some built in diversification as a basket of stocks.

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