Bookmark and Share 6, How To Write A Covered Call

Disclaimer: This example is for educational purposes to show how to write a covered call. Although the numbers are real, you should consult with a financial advisor before investing in stocks or options.

How to write a covered call: Buy Stocks. Sell Calls. Earn Income.

That's what our site's headline says, and that's what we're going to do right now.

For the example stock we're going to use IWM, the iShares Russell 2000 index ETF (exchange traded fund). It's a basket of 2000 stocks that trades like a single stock. We're going to use it as our example stock because (1) beginners should probably stick with ETFs to remove single stock volatility, (2) it's highly liquid (small spreads are especially good for small trades), and (3) it happens to offer pretty good covered call returns.

On Friday (Sep 3) IWM closed at 64.33 per share. In this example we are going to buy 200 shares and then sell 2 call options against it (since 1 option controls 100 shares, see Tutorial).

Covered call trade part 1: Buy Stocks.

On Tuesday, Sep 7, place an order with your broker to buy 200 shares of IWM. Let's assume you get filled at 64.33 per share, so this will cost you $12,866 (200 x 64.33) plus commission (which we are going to assume is small enough not to matter -- if you pay more than $5 commission to execute a trade like this then you may want to look for a discount broker).

Covered call trade part 2: Sell Calls.

As soon as you are filled on your stock order, place an order to sell 2 (not 200!) call options with an expiration of September 18 and strike of 63. Based on Friday's close, you should be able to sell them for 2.10. You will receive $420 (2 x $210) into your account today (remember, because 1 option controls 100 shares, when the price of an option is quoted as $2.10 that means it's really $210 for 1 contract).

Here's what we've done:

Action Cash in your account
Buy 200 shares IWM at 64.33 -12866
Sell 2 Sep 18 63 calls at 2.10 +420
Net debit (your break even) -12446

So, you've invested $12446. You are now long 200 shares IWM and short 2 Sep 18 63-strike call options. Now what?

Cover call trade part 3: Earn Income.

Now we wait. Options are a decaying asset. They lose value (time premium) as each day passes. If the underlying stock price doesn't change then you will see the time premium in the option drop a little bit each day. That is the amount of income you are earning.

If IWM is over 63 (the strike price we chose for the options we sold) by the market close on Friday Sep 17 then your options will be assigned (exercised), meaning the person who bought them will force you to sell your 200 shares for $63 each. You will lose the IWM stock and receive $12600 (200 x 63) cash into your account on Sep 18 (this happens automatically, you don't have to do anything special).

Since you received $12600 and you had only invested $12446, you have made a net profit of $154 (less 3 commissions -- one to buy the stock, one to sell the options, and one to sell the stock via assignment of the options).

If you divide your profit by the amount invested (154/12446) it works out to 1.24% in 11 days. If you annualize it (divide 1.24% by number of days you were in the investment and then multiply by 365) then you get 41%. That means if you were in a similar investment every day of the year you would make 41% for the year. That's over 3%/month, and really quite good (don't expect 3% every month; it is unlikely to happen).

But what if IWM goes down?

If IWM is less than 63 (the strike price of the options you sold) by the close on Sep 17 then the options you sold will expire worthless (i.e. you keep the $420 you sold them for, and you keep your stock) and now you can either sell the 200 shares of IWM you still have, or you can write another 2 call options against those shares for the October option cycle (when the market opens the following Monday, Sep 20).

Your break even point is 12446/200 = $62.23 per share (recall that IWM was at $64.33 when we started this trade, but our break even point is lower because of the calls we sold). If IWM is over $62.23 then you have a profit (on paper) and if IWM is less than $62.23 then you have a loss (on paper). In either case, now you can sell October calls against the shares you own.

If you need a little extra help on how to write a covered call, there are additional examples in our covered call tutorial.

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