Updated April 17, 2021
The Covered Call Strategy is an excellent way to reduce the cost basis of stock. In a previous post I alluded to Covered Calls but didn’t go into the details of the strategy other than to say that this strategy is a fantastic way to reduce the cost basis of stocks you own outright or stocks you want to own.
Today we will breakdown the covered call strategy and show you how to place the trade.
The Covered Call Strategy
High volatility offers the opportunity to collect a higher credit on the call we write. As with all trades, we want to use solid trade mechanics with highly liquid stocks. Studies have shown that entering this trade with 45 days to expiration is ideal.
We typically sell the call that has the most liquidity near the 30-delta level, as that gives us a high-probability trade while also giving us profitability to the upside if the stock moves in our favor.
The future is uncertain
Let’s say you are bullish on Twitter. You like the stock at its current price of $51.44 (as of 12/12/2020) and you want to buy 100 shares. When you buy the naked shares, you will pay the full price for the shares. In this case that would have been. $5144.00 for 100 shares of stock.
You have unlimited upside potential and unlimited downside risk. However, let’s say you would like to have some downside protection. Instead of just buying the shares you could write an out of the money call, collect credit and reduce the basis on the shares you want to own.
In this trade I bought the shares and sold a 55 call that expired in 45 days for a credit of $1.80 ($180.00). By selling this call I effectively reduced the cost of the 100 shares of stock by $1.80 per share. The cost of Twitter becomes $49.65 instead of $51.44.
Twitter continued to rise and went to about $56 near the middle of December. Since it was beyond 55, I was already in the money on the call and decided to let the trade play out as planned.
You may be asking why I would want the stock to be called away. And that is a particularly good question. In a covered call the max profit occurs, when the price of the stock is above the call strike “at expiration”
In my case this would have been $535.00. But expiration was still 30 days away and volatility was beginning to rise. Often this is an indication that the price is beginning to fall.
As it turned out, within a few days the price pulled back to $46.05 and I was below my breakeven of $49.65 and was facing an unrealized loss of $360. No worries. Time to bring the trade management mechanics into the picture.
Managing The Covered Call Strategy
Every trading situation comes with the need to make decisions. Becoming a better decision maker is one of the key benefits of options trading.
I could see from the chart that the price was close to support at the 150-period moving average (red line rising under the price action) And for me that gave me pause about closing the trade and taking the loss.
In addition, I still had 30 days left in the trade. The Optimal time in options trading to decide if adjustments are needed is at or near 21 days to expiration. So, I decided to wait.
I have always found it best not to do the shouda, woulda, coulda dance. It is better to follow your rules and manage as needed. Right after the price pulled back it reversed and started heading higher again. And by expiration the price was back above my price at entry.
Since the price at expiration was below the call strike price of 55, my call expired worthless and I still owned the shares. Now I held 100 shares at a cost basis of $49.65 because I got to keep the call credit I received, when I put on the trade.
The next decision was to decide if I should sell the shares and take the profit or do the trade again.
The Final Decision for this trade series
So, now I was holding shares bought at $49.65 and the current price was $54.80.
I was still bullish on the stock. The volatility had come in a bit with the rise in price. Twitter is a very liquid underlying, and I could see that the 35 delta calls in the next cycle were paying a premium of $2.10 for the 60 calls.
This cycle was also 45 days to the next expiration, so I jumped on it and placed the trade.
On Feb 10, the price of TWTR gapped higher and went on a run all the way up to $80.50 before pulling back into the mid 70’s by expiration.
Since my 60 call was now in the money, my shares were called away at $60. and I came away with a nice profit ($60 -$47.55 = $12.45 ($1245.00).
Writing a Covered call is a bullish strategy that enables you to buy shares at a discount to the current price and profit if the stock goes up, stays the same or goes down a little.
The Covered Call strategy is one of the best first trades a beginning trader can use. You have bought stock and are comfortable doing that.
Adding a covered call will reduce your cost basis and increase your probability of success.
Be sure to know your risks before entering any trade and keep your size within a manageable range.
Start small and choose highly liquid stocks with high volatility. Read here about developing a trading discipline using highly liquid stock.