Covered calls are a type of trade we frequently discuss on our podcast, as it allows us to purchase shares of a stock at a reduced price. We put this post together to help beginners better understand the process, as options and complex orders like covered calls can be confusing. Please keep in mind that what follows below is an example for informational purposes only. As anyone who follows us will tell you, we are not licensed nor professionals. Please do you own research and consult with a professional before making any trades!
Step 1: Picking a Stock
The first step to purchasing a covered call is to figure out which company you want to buy shares in. The premise of a covered call is to sell one call option contract per 100 shares purchased. Since this is a bullish trade, we want to pick a stock that we believe will rise in value in the short term. If this is your first time trying to execute this strategy, it’s also best to pick a stock with low volatility and lower price per share. For this example, we’ll use Ford (F).
As can be seen in the chart above, F has seen overall positive movement over the last 6 months and is trading at jus over $12 per share. We can also see that it has recent lower support around the $11.50 range, which will come in handy when selecting which calls we want to sell. Up to this point, we have not purchased any shares. Once we have completed our research, the trade will be executed in one move.
Step 2: Selecting the call option to sell
Now that we have selected our stock (F), and we have an idea of a good entry point (under $11.50 for the total transaction), it’s time to look at the different call options available. Since time is an important factor and makes up much of the value of an options contract, we want to look at calls expiring roughly 30-45 days from today. For the strike price, we want to sell the call that is closest to Ford’s current share price. In this case, that’s the $12 strike price. The last thing to consider is the volume of the contracts we want to sell. If the volume is too low, it will be harder to sell for a good price. Low volume means the difference between the Bid and Ask prices will be higher. For our purposes, the 5/21 expiration meets most of our criteria.
Step 3: Executing the Covered Call
The F 5/21 expiration, $12 strike call options are seeing good volume, so we should be able to sell calls for $0.90 pretty easily. At this price, our total cost to purchase shares of F will be $11.27 per share (Current price of $12.17 – $0.90 for the premium received when selling the call). I use TDAmeritrade (entering the order may be different depending on which platform is used), and the process to enter the trade looks like this:
– Under the “Trade” dropdown menu, select “Options.”
– Select “covered call” for options strategy and enter “F” for the underlying symbol.
– The first action is “Buy” and quantity “100.”
– The second action is “sell to open” “1” contracts “5/21/21” expiration “$12.00” strike.
– The order type will be “Net Debit” and we’ll enter $11.27 under premium.
It should look something like this:
Step 4: Wait until expiration
Once the order is reviewed and submitted, that’s it! Now all you have to do is wait until the option expires. If F shares finish above the strike price of $12 per share, we will realize a profit of $0.73 per share, or roughly 6.5% return on our investment in 45 days. The call contract will expire worthless if the share price finishes below $12 per share. This means we keep the premium and the shares and can then either sell another call contract or close out our position. Any price over $11.27 is profitable.
There are a couple things to keep in mind when trading covered calls. Foremost is that the shares should not be traded as long as the call contracts are open. Selling naked calls is extremely risky since there is no theoretical upper limit to a share’s price. If the shares are sold early and the call contract expires in the money, then the seller (us in this case) would have to purchase shares at the current market value in order to sell to the buyer at the strike price. There is also still the risk of the stock dropping in price more than expected, which is why it is better to stick with blue chip companies when learning how to utilize this strategy.
Since we are basically pre-negotiating our sell price when we purchase our shares, selling covered calls is better suited to generating a slower, but more reliable income stream. This means there is less risk, but it also caps our maximum profit potential. That’s ok though, because as we’ve been learning from successful traders, small consistent gains beats swinging for the fences in the long run.
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