Back to Basics: Covered Calls

Back to Basics: Covered Calls

Posted On December 9, 2022 3:44 pm

As I mentioned earlier in the week we are in something of a waiting game mode as markets remain range bound ahead of next week’s FOMC meeting.  Of course that doesn’t mean that stock’s aren’t moving within this wide range; in fact this morning the S&P 500 Index dropped 2% in about 90 seconds following a hotter than expected Producer Price Index (PPI) report. As of midday it’s been hovering on either side of unchanged.

As I said, it would be nice if we could get past these knee-jerk reactions and being held hostage to Fed words and actions. Until then Options360 is watching, waiting and selectively acting on attractive set-ups such as the position in Visa (V) I discussed yesterday.

While waiting, I thought it would be a good time to go back to basics. Remember part of the appeal of Options360 educational component not just from the Alerts and webinars but also free access to The Options Academy I host every Monday with Micheal Honig.

Let’s start with the covered call as it is one of the first and most popular strategies that traditional stock investors, who don’t necessarily consider themselves ‘option traders’ employ as they expand their trading tool box. 

Covered calls are way for people, particularly the buy and hold type, to generate income from the stocks they own. It also provides an immediate discount to the purchase price of shares from their current price.

Let’s look at a quick example using Microsoft (MSFT), which after getting smacked around following last night’s earnings report, is now down 28% from its 2021 highs.

With MSFT currently trading $245 per share, one could sell the January 260 strike calls for $5.50, meaning you’d collect $550 for every contract sold. 

But remember, each option represents 100 shares, so a covered position would be a purchase of 100 shares of the stock vs. selling one call.

In this example, your cost basis for MSFT is immediately reduced to $240 or a 2.0% discount to the current price.

The 260 call is 7% out-of-the-money, meaning if shares were above 250 on the January 20 expiration date, you could have the shares ‘called away’ and realize a 9% gain in just 45 days.

Now that we have some math on a specific example, let’s drill down into the details of covered call.

When a trader writes a covered call, usually they are looking to sell time decay (Theta), a component of premium. They often will not consciously understand that, but when quizzed, that is generally their objective. Selling premium can mean many things, but in this context, we mean selling extrinsic value.

Extrinsic value is the component of an option price most influenced by time passing, the underlying symbol price changes, as do the buying and selling pressures of the option itself. Intrinsic value, the other component of an option price, is the actual value of the option at expiration; the real, tangible value. The intrinsic value is only a function of the underlying symbol price and the option type (call or put). The intrinsic value of an at-the-money or out-of-the-money option is zero. 

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Near-term premium is what is most often sold. Here is a graph showing how the value of premium is not linear given time. An option will lose much less value over a day passing, when it is 60 days from expiring than when it is five days. The risk with covered call writing is that the underlying symbol will appreciate, causing the buyer of the option to exercise it, or worse, depreciate, leaving the seller with a premium against a devalued underlying symbol. Selling near-term premium optimizes the highest selling price with the least amount of time to wait for that price to decay. Our intention is to buy our call option back at a much lower price or let it expire worthless.

Note, time decay is not linear, it accelerates as the expiration date approaches.

The intention is to sell multiple cycles of premium against the underlying stock. Every cycle you sell premium against an underlying, and it expires worthless, lowers your investment. The profit of the previous cycle is subtracted from your investment. The profit of the current cycle over the lowered investment, exponentially increases your return on invested capital. Each subsequent cycle, you have a lower cost basis while collecting income of the option premium collected and dividends pay out.

Aside from AAPL, some other blue chip stocks one might consider for covered calls include Microsoft (MSFT), Wal-Mart (WMT) and McDonalds (MCD) which all have solid balance sheets, pay a decent dividend are likely to emerge from this crisis with even greater market share.

For those that want to be a bit more speculative might look at energy stocks which have been decimated. For example Exxon (XOM) which is down some 60% in the past two months and now offers a 10% dividend yield.

You can learn about this options strategy, as well as the many, many more we use when you join the Options360 community. It is not only my goal to arm you with an arsenal of options strategies, but to demonstrate these in real time to build your confidence in executing these trades on your own.

If this sounds like something you are interested in, then I implore you to give Options360 a try with my one-month trial, which will be available to you for $19 for the first month. If you are not satisfied with the wealth of information this service makes available to you, cancel anytime and get your money back.

However, it is my firm belief you will get plenty of bang for your buck. Find out today!

About author

Steve Smith

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.