Editor's Note: The covered call is one of many strategies options traders use to maximize profits. Tom broke this popular strategy down for readers back in 2015 - and because a thorough understanding of options vocabulary and strategies is so critical to success, we're sharing it with you again today. Here's Tom...
Buy-and-hold investors often watch volatility eat away at stock gains.
But there's a simple way to boost your return on investment while you hold shares for their long-term price appreciation and dividends.
One of my favorite strategies is to use leverage to get the absolute maximum profit performance from my shares each and every month.
Now, for the greatest profits and the least risk, it's critical you understand exactly how to use this strategy and when.
That's what I'm going to show you today...
Introducing... the "Covered Call"
One of the reasons I love options is that you can use them to accomplish nearly any financial goal.
With this options strategy, you actually own the shares, and you're selling the right to buy those shares on or before a specific date.
To execute a covered call, one first has to own stock or buy stock - which then may or may not be bought from you. I'll get into that in just a moment.
Consider this easy example...
Let's say you sold an XYZ Corp. Feb. 16, 2018, $50 call against a block of 100 XYZ Corp. shares that you own.
Now, let's say the market pushes that stock price to $57.
Someone out there may think it is better value for them to exercise their option and buy your stock at $50 instead of $57 per share - even if they paid a $2 premium for the right to do so - and they have until Feb. 16 to do it.
Of course, their $52 cost (that is, $50 for the stock and $2 for the option) is better than the $57 market price of the stock, so they make a profit.
But if you are not called out before the contract expires on Feb. 16, you get to keep the $2 premium you picked up when you sold the option. So, by our example here, you would keep $2 for every 100 shares, giving you a profit of $200.
For you, that's the best-case scenario because you get to keep that premium... plus your stock.
And you can look out at the next month (or even further) and decide whether you want to put the stock up for sale and get paid to do it - all over again.
This strategy can be expensive, but the expense comes from owning at least 100 shares of a stock.
One of the most important considerations about this strategy is if you're willing to sell the stock if you get called out. If you can't bear to part with the stock, don't write covered calls on it.
But if you already own stock and you don't mind if it gets bought from you, then this can be a great way to generate some additional income each month.
Now let's look at a real trade from July 2015 - one that paid off nicely for Power Profit Trades readers.
It's the perfect example of this strategy...[mmpazkzone name="in-story" network="9794" site="307044" id="137008" type="4"]
How We Effortlessly Beat the S&P 500
Amgen Inc. (Nasdaq: AMGN) is an easy-to-trade, liquid mid-cap biotech. Back on July 6, 2015, it was trading at $154.50, so a minimum of 100 shares would cost $15,450.
There's that outlay: Remember, the expense in this trade comes from owning 100 shares.
We picked up our 100 shares for $15,450 and then we "wrote," or sold, a covered call. You'll come across that terminology often in your options trading; to "write" an option is to sell it - that never changes.
Now, it bears mentioning at this point that you can sell "naked" options on shares that you don't own. But, like the name suggests, that's a risky play. It's definitely safer to go "covered."
With monthly cash flow in mind, we looked for an options expiration date around a month out from July 6. For our purposes, we decided to go with an expiration of July 31, or July Week 5.
At that time, we sold the AMGN July 31, 2015, $155 calls (AMGN150731C155) for $4.08.
So in our trading accounts, we took the cost of 100 shares of Amgen, or $15,450, and then took in for the sale of the options contract, or $408. So our cost basis in the stock was reduced to $15,042.
Put another way, we bought 100 shares at $15,450 and took in $408 for the calls we sold.
That's a monthly return of 2.7% for very little effort.
In a month when the S&P 500 couldn't even give us 2% gains and "high-yield" bank CDs could barely manage 1.5%, those are superior returns.
The Risks and Rewards of a Covered Call Trade
Consider the following possibilities that can occur to the covered call trader:
1) The stock price stays flat or moves up a bit, but not enough to risk getting called out.
- Pro: This works out so that your sold option expires and you keep the premium as well as the stock and look to repeat the process for another covered call paycheck the next month. With this hypothetical example, 2.7% a month adds up.
- Con: The stock could drop significantly on you. You still get to keep the premium of the option sold, but what good is a 2.7% ROI from the covered call strategy when your stock is down 30% to 40% in value? You have to spend a lot of time trying to get that stock up to break even, and that includes writing covered calls each month to do so.
2) The stock rises above the strike sold and you get called out of the stock.
- Pro: Depending on what you paid for the stock and the strike price sold, you could obtain a profit on the stock, earning money for that and keeping/making the premium on the call option sold.
- Con: The stock you bought for $154.50 and sold a $155 strike call for $4.08 goes up in price starting the next day. You get called out on AMGN. This is an "opportunity risk."
- Now, under this last scenario, you made $408 on the option, plus the gain of $50 in the stock for total profit (less commissions and fees) of $458. But... if the stock goes much higher in the ensuing days, you miss out on all that upside profit - unless you buy back into the shares.
That's why it's so important to find a stock that you feel okay with selling - if it comes to that.
You're looking to do the covered call for income over and above just selling the stock outright, and if you get a month or two more of opportunity to do that with a stock, then so much the better.
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Tom Gentile is America's No. 1 Pattern Trader, and for good reason. Since 2009, he's taught over 300,000 traders his option trading secrets, including how to find low-risk, high-reward opportunities. Now he's sharing that insight with you. To get started, just click here - you'll get Tom's twice-weekly Power Profit Trades delivered directly to your inbox, free of charge.
About the Author
Tom Gentile, options trading specialist for Money Map Press, is widely known as America's No. 1 Pattern Trader thanks to his nearly 30 years of experience spotting lucrative patterns in options trading. Tom has taught over 300,000 traders his option trading secrets in a variety of settings, including seminars and workshops. He's also a bestselling author of eight books and training courses.