Cash Flow Trader Blog: Covered Calls
A couple of years ago, my across the street neighbor bought another house on our street. He pays to have the grass cut, he keeps the utilities on, and the property appreciates; but that is it. For money-minded people like you and me, that seems crazy. He could easily be renting the house and earning steady, additional monthly income.
But what if I told you that you might be doing the same thing with your stock right now? Yep. Right now, millions of people are just sitting on stock in an account when they could be using it to create monthly 'rental' income using this one brilliant strategy: the Covered Call.
What is a Call?
A call option gives the buyer the right but not the obligation to purchase 100 shares of a stock at a specific price on or before a particular date.
What Makes a Call 'Covered'?
A call is considered 'covered' when the seller of the call option owns the underlying security. To use this strategy, you must own at least 100 shares of the stock you consider writing a call on.
Why Covered Calls Can Be Major Money Makers
Do any of these possibilities sound exciting to you?
- Generating additional income when a stock is neutral to bullish, with a guarantee that you'll receive your premium!
- Having a predictable way to generate cash flow.
- Lowering your cost basis.
- Selling stock at a target above the current price.
- Being able to "close early" and remove the obligation to sell the stock.
- Increasing downside protection.
These are just a few of the reasons why we love the covered call strategy. The Covered Call Strategy is a compound strategy. It has two parts: buying a stock and selling a call. If you already own 100 shares of the underlying stock, you can skip the first step.
The buyer of the call pays a premium for the right to buy the stock at the strike price. As the seller, you receive the premium in exchange for giving up some of the potential upsides of the stock price. If the option expires worthless, the seller still keeps the premium. Can you see the potential yet?
Your Step-by-Step Guide to Optimizing Covered Calls Results:
Step 1: Pick a Stock
When choosing stocks for covered calls look for:
- • Stocks you want to own
- • Neutral or bullish trends
- • Stocks trading over the EMAs
- • 1M+ in volume
- • Optionable
Here are a few things to avoid:
- Bearish trends. Covered calls work best in a neutral or bullish market.
- Pending news that could be negative
- • Earnings aren't a good thing.
- If you have reason to believe a stock might "take off," just hold it.
Step 2: Analyze and Identify Direction
Do your general analysis as you would on any stock you were considering. Check support and resistance, moving averages, Stochastic, etc. Determine which direction the stock is trending. You might even want to start a watchlist! A great time to sell a covered call is at a resistance point with Stochastics turning down from overbought.
Step 3: Buy Stock
- Buy the stock in increments of 100.
- Sell covered calls 1-2 strike prices above the current price.
- Look at 3-4 weeks until expiration to take advantage of time decay.
Step 4: Exit the Trade
There are three methods to exit the Covered Call trade. No matter what happens, you can "cover your backside." Yes, that pun fully intended.
Method 1: If the underlying security stays out of the money, you keep the premium and let the option expire worthlessly. This method is preferred.
Method 2: Buy the option you sold back for less. Assuming time decay decreases the option's value, place an order to buy back the option at a reduced price. You then keep the stock and could sell another month's call at a higher strike price if you want.
Method 3: If the underlying stock price increases to or above the call strike price, you may either buy to close your option at the current market price and keep the stock or hold the trade and get "called out," which will require you to sell your stock at the agreed price. You can then repurchase the stock if it fits your plan.
Risk and Requirements of Covered Calls.
As with anything, The Covered Call Strategy does have a few potential downsides, especially if you are growing a smaller account right now. The Covered Call Strategy requires more capital to execute than a typical long trade, and you must have at least 100 shares of the chosen stock in your trading account.
There is also the risk that the stock value will go down during the trade. However, this is a risk of owning any stock in the first place, whether you place a covered call or not.
Finally, there is the risk of unrealized gains. If the stock suddenly skyrockets while your covered call is open, you are still obligated to sell shares at the agreed price, even if that price is well below the current value. In this instance, you do not actually lose money. You lose the potential you had to sell the stock at a higher price.
Managing Risk for the Covered Call Strategy
There are two simple risk management rules you should always live by:
- Do not tie up more than 20% of your account with any single trade.
- Always have a stop! For the Covered Call strategy, you would "buy to close" to exit the trade if you hit your stop.
In Closing
There are various ways to trade and after reading today’s blog we hope you would take a look at the Covered Call strategy. It is a fantastic way to generate repeatable cash flow and accessible to new options traders like myself. Join us next Thursday where we take a look at The Top 5 Favorite Candlestick Patterns.
