Playing it “safe” with a Covered Call strategy

Does such a thing actually exist? Well sort of… and its known as a Covered Call.

The strategy is simply the purchase of 100 shares and the simultaneous sale of a call option.

The covered call is both an introductory and advanced trade for it’s simplicity, but also for its ability to teach new traders the concept of hedging and introduce them to short selling for premium(very important!). Additionally, it’s among the most promoted of all strategies because…well..it works

In fact, I can virtually guarantee that thousands of traders never place any other type of trade. They churn out premiums from the sale of call options without any intention of ever actually releasing the underlying shares. In an instance where they may have to they’ll either buy them back afterward or simply close the short call in the open market prior to expiration.

 

Trade Example

But lets start at the beginning and take a closer look at this potentially lucrative strategy with an example using Think or swim’s OnDemand feature…

 

Nike example Covered Call
Nike Example Covered Call
Current Nike Share Price – $57.09
Current Short Call Premium – $1.25

 

Breakdown

Max profit potential: Strike price ($57.5) – Stock Price ($57.09) + Premium Received ($1.25) = Max Profit ($1.66)

Max loss: (Share price could trade to zero.) – $55.84 * 100 = $5,584

Opportunity loss: Share price could trade infinitely higher.

*These are the parameters when the trade is initiated.

 

Breakdown Analysis

At first glance these figures may not be too appealing. A relatively meager profit potential with a rather large potential loss. However, I encourage you to consider the risk of just owning the shares outright and by that comparison I think we can agree less risk is accepted by selling the call simultaneously.

Sadly though, for every benefit their is also a detriment, we must sacrifice the upside profit potential of just owning the shares alone.

It should be noted that if a move higher is expected, the trader could simply sell the call at that time into the options market. Uncapping the upside profit opportunity and if the share price begins to consolidate or move lower the call could be reopened. Basically creating a cycle of profit opportunities. For instance, profit when share price moves higher, then open short calls to profit when share price stalls or retreats.

Profit when share price moves higher, then profit from short calls when share price consolidates.

Let’s get back to our hypothetical trade and I’ll discuss rationale.

 

Nike Covered Call Example Chart
1. Down-trending share price
2. Down-trending MACD
3. Low volume on price spike
4. Expecting price to decline to previous low

Admittedly, this would be a difficult trade on this particular day. If this were a real money account I would have waited for the following day to see price behavior. As it is however, we’ve entered the trade this day with good reason, based on the analysis listed in the image caption.

With modestly lower price expectations in the near term, a covered call makes sense. Unfortunately, we’ll likely lose money on the “covered call position itself” but it will open the door to potentially lowering our cost basis even further with the sell of another call option.

Let me explain.

In this example;

  • purchased 100 shares for $57.09
  • received $1.25 for selling the call
  • Share cost basis = $55.84 (the amount it cost to initiate the trade)

 

Nike Covered Call Example Trade Week 1
Nike Covered Call Example Trade after 1 week

 

Notice, I highlighted the short call. I did so because we’ve profited $81 of a potential $125, leaving only $44 dollars of potential profit remaining in this contract. At this point a decision will need to be made about whether to continue holding the $57.50 contract or sell another to collect additional premium and lower the cost basis, as mentioned above.

The decision is essentially, will Nike’s share price continue lower or rebound. A rebound would likely result in the overall position becoming profitable. A continued retreat would allow for additional premium. Let’s take a second look at the chart and see what happens.

 

Nike Covered Call Example Chart Week 2
Nike Covered Call Example Chart after first week.
Still expecting Nike to touch previous lows.

 

From this chart I think it reasonable to conclude that Nike is still heading lower. Of course, an argument could always be made in favor of a move higher but that would defy probability. And with a continuing decline expected, I’ll choose to capture some additional premium and lower the share price cost basis even further.

 

Nike Covered Call Adjustment Order Example
Nike Adjustment order example

 

And here is the position statement after a continued decline to Nike’s share price and the sell of the $56 strike call.

 

Nike Covered Call Example Position Statement
Nike Covered Call Example Position Statement after closing $56 strike call option.

 

In this particular example we’ve actually lost money on the covered call position. In fact, we’re in the hole by ($189.00). However, we’ve lowered our true cost basis from $57.09 to $55.44.

Lets consider possible scenarios from here;

  • Stay long the shares while share price increases to overcome our current deficit, turn a profit, and possibly move on.
  • Open a new call, hope for a decline in the near term, further lower our cost basis and continue the same cycle discussed above.
  • Open a new call with a strike price above our true cost basis – giving us the ability to sell our remaining shares (*If assigned) for more than our original investment. I.e. a profit. Or potentially lower our cost basis even further and continue the ongoing cycle.

 

Now consider if I had made each of those decisions, what could be done if I was wrong? (bullets correspond with bullets above)

  • Share price continues its decline and larger losses result with no additional premium gained through the decline.
    • Elect to reopen a short call, possibly with a cushion between share price and strike price.
  • Share price rallies resulting in losses to the short call but gains to the share position.
    • Elect to close for a loss the short call to capitalize fully on the upside share movement.
  • Doesn’t matter which direction share price moves. This is a win-win position.
    • If price moved higher I would hold to call until expiration and force assignment for more than my true cost basis.
    • If price moved lower I would continue lowering my cost basis.

I hope this example and the scenarios I’ve laid out here are beneficial, it was considerably longer than I had anticipated but I believe it documents many of the possibilities with this strategy. It’s certainly a powerful strategy and I for one wouldn’t ignore it.

Please comment below with any questions or concerns.

Happy Trading,

Jeff “the Option Boxer”

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