How to Write Covered Calls
An Option Strategy for the Novice Investor
When learning to use options, covered call writing is a good, basic strategy to adopt because it offers the opportunity:
- To own stocks with less downside risk, compared with other stockholders.
- To earn more frequent profits and to have fewer losing trades compared with other stockholders.
There is a cost to gaining those benefits. Profits are limited. Therefore, it is not appropriate to adopt this strategy when you invest in companies whose stock price is expected to double every year.
This strategy is for investors who want to earn good, but limited profits.
How it Works
- Buy 100 shares (or multiples of 100 shares) of a stock that you want to own.
- Write (sell) one call option for every 100 shares. That call is "covered" because you own stock that can be delivered to the call owner, if and when you are. NOTE: If you do not own the stock, then the call sale is "uncovered" or "Naked."
- The cash (premium) that you collected when selling the call option is always yours to keep.
- By writing the call, you agree to the terms of the option contract. In this example, you are obligated to sell that stock -- at the option strike price -- but only when the option owner elects to exercise his rights to buy your shares.
- If expiration passes and the call owner does not elect to buy the stock, then the option is worthless and your obligations end.
YFS (Your Favorite Stock) is currently trading at $43.80 and you buy 100 shares.
Your outlook for this company is positive (that is why you are buying shares), and you hope to earn 10% to 15% per year as the company continues to grow. However, rather than just hold onto the shares, you adopt the covered call writing strategy with the hope of increasing your profits.
There are always several choices for an option to sell.
They come with different expiration dates and different strike prices. Let's assume that you choose to sell one call option that expires in 60 days (Mar 19, 20XX). Let's further assume that you are willing to make a commitment to sell the shares at $45 per share at any time on, or before, that expiration date.
Which Call Option to Sell
How do you find the right call option to sell? Choose a YFS call option with
- The correct (i.e., it satisfies your needs) strike price.
- An appropriate expiration date. Longer-term options come with a larger premium, but you are committed to a longer holding period. Shorter-term options allow for a shorter commitment, but the premium may not be high enough to warrant selling the call.
Two trades are required:
a) Buy 100 shares. You already made this trade, paying $43.80
b) Sell one call option:
YFS Mar 19 'XX 45 Call
YFS is the stock symbol.
Mar 19' 20XX is the expiration date.
45 is the strike price (i.e., $45 per share).
Call describes the option type (put or call).
The image at the top of this article illustrates the profit/loss profile. Note: The maximum possible profit is $320. How is that maximum earned?
Bought stock @ 43.80
Sold stock (when assigned an exercise notice) @ $45.
Premium collected from option sale @ $2.00 per share, or $200 cash.
Net sale price is $47.00 [$45 from stock sale plus $2.00 from option sale.]
Net sale price ($47) minus net cost ($43.80) = $3.20 per share, or $320 profit (less commissions)
That is a return equal to 7.3% ($320/ $4,380) is 60 days.
NOTE 1: The maximum possible profit is earned when the stock is above the strike price when the market closes for trading on expiration day. It is always a good result to achieve the best possible result when making any trade. Don't feel bad when your stock is sold at the strike price. Keep in mind that this was the target profit at the time the trade was made -- and meeting your profit targets is the path to being a successful investor or trader.
NOTE 2: If YFS is below the strike price at the close of trading on March 19, 20XX, then the option expires worthless and you still own the stock. As a stockholder, you can hold the shares, sell them, or write another covered call.