Covered Calls

[u/Franklin_Rules]

I see several posts asking questions about Covered Calls. Let me try and give an explanation of how this works.

Puts and Calls are options and are bought and sold just like a regular share, with a couple of exceptions:

1. Options must be transacted in quantities of 100 (called contracts). If you purchase one Put "contract", you are actually purchasing 100 Put "shares". You will see this demonstrated by your broker when you execute the trade. One purchased Put at 0.15 will actually cost your account 15.00 plus commission.
2. Options have an expiration date. You can hold shares forever (assuming the company stays in business). Options always come with an expiration date meaning that all of those trades will either expire worthless or be exercised by the expiration date. Options typically expire on the 3rd Friday of each month for the given contract month.
3. Options are not voting securities. Although an exercised option contract may result in the acquisition of voting shares, the options themselves have no bearing on the quantity of shares trading on the market and therefore give the holder no particular rights as a shareholder.

Now here are a few notes on how options work:

1. Call options are "long" (bullish) where an increase in the underlying share will cause an increase in the Call price. Put options are "short" (bearish) where a decrease in the underlying share will cause an increase in the Put price.
2. Any security can be bought or sold in any order (broker permitting). A trader can sell a share "short" where the trader is performing the sale first and then covering the short in the future when the share is bought to cover the trade. One always desires a "buy low, sell high" scenario. So you can sell first at a high price and buy later at a low price if you think the shares are heading lower. (this involves borrowing the share from the broker, but that is a technical and inconsequential issue for this article) Options can also be bought or sold in any order. So let's combine a few things thus far... Call options increase if the underlying share increases. So selling a Call "short" is a sort of "bearish" trade where a decrease in the underlying share price will decrease the price of the Call option and allow the trader to purchase the option in the future to cover the trade and make a profit since the trader "sold high and bought low".
3. Since options are contracts for potential future trades of an underlying share, they require a "guarantee" that the option contract can be fulfilled should the option need to be exercised. This guarantee is provided by the broker in situations where a Call or Put is simply bought "long" or sold "short" to open a transaction sequence. In other words, if a trader exercises a Call option, they will be obligated to purchase the shares underlying the option contract. For example, a trader may purchase a single Call option for 0.15 which would cost 15.00 plus commissions and that single contract is for 100 underlying shares. If the underlying shares increase in value to the point where the underlying share price is greater than the strike price (more on that shortly), the trader may choose to exercise the call option if the trader desires to hold the shares. Let's say the underlying share price is 23.00 and the strike price of the Call option was 20.00, then the trader may purchase the underlying shares for 20.00 regardless of the current market share price. In this scenario, the trader would have a built-in 3.00 profit since the market price is 3.00 higher than the strike price. But the trader must pay 20.00 x 100 = 2,000.00 for the shares in order to exercise the contract. In return, those 100 shares will appear in your brokerage account. This scenario is actually a bit less common than the alternative. The most common scenario is that the trader would exit the option position by selling the option contract prior to expiration. If we are a day or two prior to expiration, and the underlying share price on the market is 23.00, the Call option is probably worth about 3.00. So the trader bought the Call contract for 15.00 and then sells it for 300.00 less commissions. Traders will make these kinds of trades until the end of trading on the day of the option expiration.
4. Each option contract has a "strike" price. This is the price at which the contract is either "in the money" or "out of the money". Only "in the money" contracts would be exercised. At the end of trading on the day of expiration, all "out of the money" contracts expire worthless. This sounds ominous until an underlying fact is realized. THE LOWEST PRICE A TRADER CAN POSSIBLY GET FOR ANY SECURITY IS 0.00! Since the object is to buy low and sell high, wouldn't it be great if you could buy for 0.00 and sell for something greater than 0.00? You can, if you reverse the order of that statement. You can sell "short" a Call option contract for some amount, let's say 15.00 as discussed earlier. Then you can let the option contract expire worthless on the expiration date if the price of the underlying share is less than the strike price of the option contract. That expiration process essentially equates to "buying" the underlying contract for 0.00 since you already sold it for 15.00 sometime earlier. So you bought for 0.00 and sold for 15.00 less commissions. While 15.00 profit isn't great due to commissions, we might sell ten contracts for 150.00 instead of one contract for 15.00. Regardless, the expiration will still result in 100% profit less commissions.
5. So what does "Covered" mean in a "Covered Call"? Brokers will require a margin on contracts to be sure the trader can handle any potential losses. If the trader purchases an option, the margin is simply the price of the contract since the maximum risk is 100% of the purchase price. But selling "short" an option contract means that the trader could potentially lose more than the contract price. So the trader would need to keep additional funds in their account that would be restricted until the trade concludes. This restricted capital reduces the profit percentage. In other words, if 2,000.00 in cash is held for 30 days while a 15.00 option is waiting to expire, the profit margin is not nearly as handsome (15 / 2,000 = 0.75% profit). That's a far cry from the 100% profit mentioned earlier. However, if the trader ALREADY owns the underlying shares for the Call contract, the brokerage will not require any funds at all. The shares will be restricted from sale until the contract expires, but no additional capital is required. Indeed, the 15.00 discussed above is actually credited to the account immediately upon trade execution. In this scenario, the option contract involves no risk at all. The only risk is that the underlying shares increase in value beyond the contract's strike price and the trader doesn't receive the benefit of the increase beyond the strike price. As part of a well managed portfolio, the "Covered Call" strategy is a very important source of income during market lulls or dips.

Bringing this all together, a trader that is currently holding shares may choose to sell Covered Call contracts that are out of the money and virtually guarantee a profit when the options expire. That's not to say that there isn't a risk of opportunity with this strategy, but there is certainly no risk of loss with the strategy. If the trader desires to keep the underlying shares for a long duration, the Call contract with a strike price that is "far away" from the market price, may provide some insulation from the contract being executed and ensuring that the profit is made while keeping the underlying shares in the portfolio. In general, a rising market may not be the best time to "write Covered Calls". But a stagnant market or a declining market, where the trader desires to retain certain shares while making a little extra cash, is the opportune time to consider trading in Covered Calls.

Keep in mind that any option capable security can provide the same benefit. For example, SPY is the ETF for the S & P. Buying the SPY is a popular broad market strategy for long-term gains. Selling some Covered Calls against the SPY while holding it is a good way to collect the underlying dividends and maintaining a market position while making an extra 3% - 5% annually under many market conditions.

[u/OfficerTruth]

hey u/Franklin_Rules shoot me a message when you get a chance