Are you interested in options trading? If so, be smart: take the time to learn the basic strategies. Let’s start here with a common one: the covered call.
“Covered call” might sound like a telemarketer scam … But don’t worry: it’s a real trading strategy. It’s a super common options trading strategy. Traders use it to try to earn extra profits from stocks they already own. How? They potentially collect premiums on unexercised options contracts.
Some so-called gurus will tell you this is a fast-track method that’s guaranteed to make you millions. Sorry, but no. There are no shortcuts or sure things in trading. Ever.
And there’s a lot you need to know before you can hope to be consistent with this strategy.
So let’s dig in and talk about some of the things you should know before you start with options. In this post, I’ll tell you all about covered calls, including what they are, how they work, and when to use them.
Whether you’re an aspiring options trader or beefing up your trading education, you won’t want to miss this.
Table of Contents
- 1 What Is a Covered Call?
- 2 Example of a Covered Call
- 3 Advantages of Covered Calls
- 4 Risks of Covered Calls
- 5 How to Place a Covered Call
- 6 When to Sell a Covered Call
- 7 Covered Call Formula
- 8 Best Covered Call Tips
- 9 The Final Word on Covered Calls
- 10 One Platform. One System. Every Tool
What Is a Covered Call?
Before you can understand a covered call, let’s back up a little. First, you need to know what a call option is and a basic understanding of how it works.
Let’s talk about it from the point of view of the buyer of a call option.
The call option is like a down payment on a potential future trade — but only if it meets certain criteria. An “if … then” kinda deal.
It’s a contract that gives you the right to execute a buy order on a specified amount of shares at a set price within a certain period.
If you’re looking to buy, you want to stake a claim on the stock. And for that right, you pay a down payment to the seller.
Now, let’s switch the seller’s point of view. There are two sides to every trade, right?
In this situation, the seller could have a strategy for the trade where they collect that premium and not give up the stock … That’s called a covered call.
So with a covered call, you’re the one with the pot of gold — or a pile of stock shares. You’re saying, “Sure, I’ll sell you these shares by way of a call option.”
But in your heart of hearts, you hope the potential buyer won’t exercise the option. And that means you get to keep that down payment.
So when the contract expires, you keep the down payment and your treasure.
Psst … want more basic options trading info? Check out this post.
Example of a Covered Call
In case it’s not clear, a covered call actually involves two different transactions.
First, there’s the transaction where you buy the stock.
Say you buy shares of Stock X for $50 per share. You feel good about the stock’s long-term prospects. But you also think that in the near future (or at for the contract term) it won’t move much. It might even drop a bit in value.
In this case, you might sell a call option. Basically, you hope that someone who’s more optimistic than you about the price will be wrong. This way, they won’t exercise the option. You get to keep the premium and hold on to that stock that could still go up in value later.
Covered Call vs. Protective Put
Now you know what a covered call is … But the difference between this strategy and the protective put might confuse you.
A protective put is a way to potentially hedge with a put option. Here, a buyer worries that a downturn or crash could change the value of the underlying stock. But the thing is, the contract is already in place.
The protective put acts like an insurance policy on a previous purchase. It can’t prevent losses, but it can potentially help reduce them.
Covered Call vs. Naked Call
No, this didn’t just turn into “Traders Gone Wild.” The naked call is another common options trading strategy … but it’s riskier than a covered call.
A naked call is very similar to a covered call. But there’s a crucial difference — you don’t actually own the underlying stock. Yep: you’re trying to profit using stock you don’t actually own.
With a covered call, you’re playing chicken with your stock shares. You could lose them if the buyer exercises the contract.
But with a naked call, it’s different. What if things don’t go as you expect and the buyer goes through with the order? You’ve got to put up the cash to buy the shares to deliver. It’s not unlike the risk associated with short selling.
This means that depending on how high the share price goes, you could be seriously SOL. Definitely not a strategy for beginners.
Advantages of Covered Calls
There are plenty of reasons why some traders find covered calls appealing. Here are a few:
- Passive income. If a covered call works out the way you hope, then you don’t have to do much. You don’t have to buy or sell shares. When the contract expires, you keep that down payment.
- Have your cake and eat it too. Well, maybe more like steak for me. But the idea is that if things go well with a covered call, you keep your stock shares, which can continue to rise in price over time. But you also potentially make a bonus payment from the premium.
- Potentially reduced risk. Say the strike price on the options contract is already above what you paid for the stock to begin with … Even if the buyer goes through with the option and you lose that premium, you still haven’t suffered a loss.
- Rewards research. You know me — I’m all about building a case for every trade. If you do a ton of strong research and build a solid case for why the stock price probably won’t go up during the contract period, you could get that sweet premium payment.
Risks of Covered Calls
One risk is that you could lose your shares. If the price of the stock goes up, the buyer will probably want to go through with the order.
So the buyer gets to collect the stock … and continue to make profits if the price keeps on rising. Meanwhile, you’re standing in the sidelines watching the game go on without you.
The biggest risk is with uncovered/naked calls, though. As with short selling, your losses can be unlimited. Did I mention that’s not a strategy for beginners? Guess what? I’m saying it again now.
How to Place a Covered Call
The covered call is a strategy that traders use, but it doesn’t require a special order type. Placing a covered call requires writing a call option for a stock that you own.
Pro tip: it can make your life easier to hold all positions with the same broker. It’s not necessary, but it can keep things from getting too confusing.
Before you start trading or trying the covered call position, your top priority should be getting clear on your broker situation.
Not all brokers offer options trading, and not all brokers who offer options trading are great. So even if you have a broker that you love, check out what people say about its performance with options. Don’t just blindly stick with one broker for all your trading needs.
When to Sell a Covered Call
With a covered call, your ideal situation is to have an overall winning position but expect the stock to go higher over time.
So the time to write a call option is when the price is moving sideways or even a little downward for a relatively short period of time. This can allow you to potentially eke some extra profits out of the stock while it’s not doing much.
However, be very vigilant! If the price starts going up, you could miss out on all the action. So you may want to avoid this strategy with stocks that have a history of spiking on news or earnings announcements.
Covered Call Formula
Looking to calculate how much you could make with a covered call?
That’s all about figuring out the premium. But there isn’t just a flat-fee pricing structure for premiums. The premium on an options contract depends on a few things, including:
- Intrinsic value: This refers to the price of the stock versus the strike price.
- Time value: This is the amount of time until the option’s expiration date.
- Volatility value: The stock’s price fluctuation.
Overall, the premium for an options contract is kind of like the price of a stock: it’s dictated by the free market.
Don’t hurt your brain trying to figure it all out on your own, though. It’s not necessary. Hit up your options broker for a quote that includes the last price, bid, and ask.
Best Covered Call Tips
Covered calls can be a successful strategy, but that doesn’t mean it’ll work every time. There’s no such thing as a risk-free trading strategy. But you can make more informed decisions. Here are some tips:
- Position size matters. Never gamble too much. No matter how “sure thing” a trade might seem, you can still lose. Never forget that.
- Don’t trade all of your position. With a covered call, you could lose stock shares that are poised to increase in value. One way to avoid missing out on potential price spikes? Only trade a portion of your underlying position. So if you have 600 shares, maybe only do two or three options contracts (that’s 100 shares each).
- Try paper trading first. Paper trading can help you gain confidence when learning new strategies. Try it before you start covered calls. If you can’t make money paper trading, you probably won’t in real life!
- Study, study, study. Study the stock’s price action. Even though StocksToTrade doesn’t offer options trading at this time, you can still use it to research the underlying stock. That can give you a better idea of the price action over time.
- Stick with good setups. As my good friend Tim Sykes says, he approaches the market like a retired trader. A trade has to be good enough to drag him out of retirement. We could probably all learn from this approach. Is the trade you’re considering so good that it would drag you out of retirement?
Nope: StocksToTrade doesn’t offer options trading. But it can still help you on your options trading journey.
While you can use options to trade a variety of different assets, stocks are one of the most popular. And to make smart trading decisions, you’ve got to educate yourself on the price action and fundamentals of the underlying stocks.
StocksToTrade is an amazing tool for helping you perform the vital stock research that can make or break trades.
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STT has all the charts, scanners, news feeds, watchlists, and a ton more … all in one program that’s available for a single monthly fee.
See for yourself why so many of the top traders love this platform. Try it with a 14-day trial for just $7 now!
The Final Word on Covered Calls
There are plenty of ways to make money as a trader … and plenty of ways to lose money.
Options are getting a ton of attention lately. Lots of so-called gurus promise insane returns if you follow this or that strategy.
My advice? Don’t believe the hype. Yes, options trading can be a way to generate income. But take the time to learn how options trading works before you start risking your money.
If you’re interested in options, think of it as a long-term prospect, not a get-rich-quick scheme.
Learn all that you can. Reading this post is a good start, but it’s really just that: a starting point. Educate yourself on every aspect of options you can, from covered calls to the Greeks to risk management.
Education is power when it comes to just about any type of trading, including options!
What do you think about options trading? Do you use the covered call strategy? Leave a comment!