Covered Calls

Andrew Keene- Have Taught 1000’s of Students to Full Time Traders- Turned $50,000 into Over $5.5 Million Trading- Active Trader in Futures, FX,

Stocks & Commodities - Regular Contributor to CNBC

& Bloomberg, Fox Business, CBOE, and more

Covered Calls

What is a covered call?

A covered call is a call sold against a traders long stock position. The

trader will sell a call at a ratio of 1 option for every 100 shares of stock.

This strategy can create an extra dividend stream over time. It also

creates a cushion to the downside if the stock sells off slightly.

In order to avoid getting hung a trader would enter this order as a

spread. Legging in by selling the call first can be very dangerous.

Covered Calls

Which Strike Should the Trader Sell?

The trader doesn’t necessarily have to sell ATM calls. If the trader

selects an OTM strike, they will collect less premium, but will leave more

room for the stock to profit on an upside move. A trader should always

sell the Strike option of where they would be willing to sell the stock.

We can combine unusual option activity with this strategy. Looking for

large put sellers then initiating a buy write on that line.

Covered Call

This strategy works best when a slow upward move in the stock is

expected. There are better ways to profit if the trader thinks that the

stock could go parabolic higher. Remember, the higher the implied

volatility, the more a trader will get for their Call option.

Also consider that while covered calls may not offer the huge reward

potential of other strategies they can make money if a stock rallys,

trades sideways, or even sells off some. This means that covered calls

can make money in many different market environments.

Covered Calls

Outlook: Bullish to Neutral. Slow move up in

the stock price until the options expiry. An

expected parabolic move in either direction is

not good for a Covered Call Strategy.

Max Risk: The price paid for the stock minus

the credit received from the short call.

Max Reward: Limited to the strike minus the

stock price plus credit received.

Breakeven: Stock price minus credit received

for Call Sale.

Covered Calls

Greeks of Covered Calls:

Theta- Time is on the side of the covered call writer. As time goes on the

option sold will lose value.

Implied Volatility: Decreases in implied volatility are favorable for a

covered call position. Again, a decrease in implied volatility will lower

the value of the option sold.

Covered Calls

Best Time to Trade Covered Calls:

On the trading floor we used to call Monday morning “Buy-Write Monday”

Putting on covered calls before the market makers “roll their date forward” is generally a

good way to trade. Time decay will also accelerate through the week as expiration

approaches.

Traders can choose to write calls against long stock positions with weekly options or

standard monthly options. Just remember that time decay and implied volatility have

different effects on these options.

Covered Calls

Reading an option Chain:

Covered calls are often the first strategy an options trader is introduced to. For an inexperienced

option trader the option chain may be overwhelming to read so lets look at what's relevant.

Things that are important to look at are:

Bid Price: This is the price that a trader is willing to pay for this option that expires on Friday

Ask Price: This is the price that a trader is willing to sell for this option that expires on Friday

Bid-Ask Size: The number of contracts available at those price levels.

Volume: This shows the quantity of total amount of options that have traded on this strike today.

Open Interest: This shows the quantity of total amount of options that have traded in the entirety of

this option.

Look at the AAPL option chain on the next slide…

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Bid and Offer Prices

Bid and Offer Size

Volume & Open Interest

Covered Calls

Example #1 Covered Call:

Shares of Apple Inc. (AAPL) are currently trading $508.00

The AAPL Feb 525 Calls are trading at $5.25

Trade: Buying 100 shares of AAPL stock at $508.00 for every Feb 525 call sold for $5.25

Reward: $22.25

Breakeven: $502.75

This trade will net its maximum profit if shares of AAPL close above $525 on Feb

expiration. The trade will also be profitable anywhere above $502.75. As you can see, this

trade can be profitable if the stock trades sideways, rallys, or even sells off anywhere

above $502.75. Doing this month over month will continually lower our cost basis on this

long AAPL stock position.

Covered Calls

Example #2 Covered Call:

Shares of Cadence Design Systems Inc (CDNS) are trading at $14.05

The CDNS Aug 12 Calls are trading at $2.75

Trade: Buying 100 Shares of CDNS at $14.05 for every Aug 12 Call sold at $2.75

Reward: $70 per 1 lot

Breakeven: $11.30

Should the stock close above $14.00 on August expiration this trade will net its maximum

potential profit of $70 per 1 lot. This trade is also profitable anywhere above $11.30.

Remember that covered calls are a synthetic short put.

Covered Call

A covered call is also a synthetic short put.

Covered Calls

Covered Calls as Synthetics:

Even though covered calls are the only strategy deemed as non speculative we can easily

see that this synthetic short put does in fact carry a lot of risk. A trader who does not

understand the risks behind this strategy can find themselves much more exposed than

they intended to be.

COVERED CALLS ARE SYNTHETIC SHORT PUTS

Covered Calls

Traders should remember that as long as they are short a call they

should not sell their stock position if they do not want to expose

themselves to unlimited risk. Naked short calls have blowout risk.

Also keep this in mind when entering the order. You do not want to try

and leg into the trade by selling the call first then buying the stock. To

put the trade on enter the order as a spread or buy the stock first then

sell the call.

Covered Calls

How to Select Specific Stocks to Write Covered Calls On:

Now that we understand the basics of how covered calls work we must discuss how to

find stocks that are good covered call candidates. In general there are certain conditions

that are more favorable for the covered call trader.

Being able to indentify these conditions can help a trader avoid lower probability set ups

and stay in the best possible covered call set ups. On the next slide we will look at our

favorite set up for a covered call trade…

Covered Calls

How to Select Specific Stocks to Write Covered Calls On:

We use a scanner to read every big block equity option trade that takes place on every

exchange in the country. We watch over 2,000 trades a day looking for a big block put

seller who meets the following requirements.

1. Volume must be greater than current open interest in that line.

2. The block trade must represent a large multiple over average daily option volume in

the stock.

3. The amount of stock that the trader would get “put to them” as a result of

assignment must represent at least 25% of the stocks average daily volume. The larger

this percentage the better the set up is.

Once we see a trade hitting the tape that meets these conditions we must then make

considerations we will discuss on the following slides…

Covered Calls

Using Charts When Trading Covered Calls:

After we see the block trade we want to make sure that it is in a stock that is trading on a

relatively sideways to bullish chart. We use a variety of technical indicators, namely the

Ichimoku Cloud, to asses the candidacy of a stock for a covered call position.

We will look at 3 different chart setups on the next slides and explain what makes some

better than others for a covered call trader.

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I do not want to trade a Covered Call in any stock where the price is trading under the Ichimoku Cloud. The momentum in VALE is clearly to the downside. Remember I want to look for sideways to bullish price action.

20

I do NOT want to trade a chart where the stock is parabolic higher. While a covered call would still likely be profitable in WWE there are better strategies to employ if a trader is looking for a long position in WWE.

21

The chart of EBAY is a great example of the type of price action we look for before putting on a covered call. Price action here is sideways but generally upward sloping.

Covered Calls

Why Would a Trader Put on a Covered Call?:

Now that we know what were looking for lets discuss why a trader would want to

establish a covered call position. Covered calls have many advantages including:

1. I can make money if the stock is rallying, trading sideways, or even if it is trading

slightly lower.

2. A trader can create an extra dividend stream for a long stock position.

3. Lowering the breakeven point for long stock positions.

Lets look at some more examples of covered call set ups we like on the following slides…

Covered Calls

Covered Call Example #3:

Shares of Microsoft (MSFT) are trading at $37.00 and the July 40 Calls are trading at $3.00

I am willing to get long MSFT and am willing to sell ALL of my stock if the price reaches

$40.00 per share.

I buy 100 shares of MSFT at $37.00 for every July 40 call sold for $3.00.

-This lowers my breakeven point to $34.00 and also leaves room to the upside.

-This trade will have a maximum reward potential of $600 per 1 lot if the stock trades

above $40.00 on expiration.

Lets look at another example of an ITM covered call in AAPL

Covered Calls

Covered Call Example #4

Shares of AAPL are trading at $550 and the July 500 Call is trading at $72.00

I believe that AAPL will trade sideways to slightly higher between now and July expiration.

Here I buy 100 shares of AAPL at $550 for every July 500 call sold for $72.00.

My breakeven is $478.00.

I have a maximum reward of $2200 per 1 lot if the stock closes above $500 on July

expiration.

This trade allows for profitability even if AAPL sells of by less than 13%. This is the same as

selling the AAPL July 500 Puts for $22.00.

Covered Calls

Why Not Trade Covered Calls in a Stock That Might Move Parabolic Higher?

If a trader believes there is going to be a parabolic move in a stock they could do covered

calls but there are much BETTER strategies they could use.

Remember that when using covered call we CAP our potential upside:

Strike Price – Stock Price Purchased plus the Price of the Call I sold

So if shares of Tesla Motors (TSLA) are trading at $175 and I think the stock is going to

move parabolic higher there are more profitable ways to trade it than a covered call.

Lets compare the returns of a covered call on TSLA vs. Other Strategies:

Covered Calls

Why Not Trade Covered Calls in a Stock That Might Move Parabolic Higher?

TSLA is trading at $175 and the Jun 160 Calls are trading at $30.

I buy 100 Shares of TSLA at $175 for every June 160 Call I sell for $30

My breakeven on this trade is $145.00. So I make money if the stock is anywhere above

this level on expiration.

However, my profits are capped in this trade:

The most I can make is- $160 - $175 + $30 = $15 or $1500 per 1 lot

If the stock rallies $10 or $1000 between now and expiration the most I make is still

$1,500 per 1 lot. Lets examine the potential return from an outright call position.

Covered Calls

Why Not Trade Covered Calls in a Stock That Might Move Parabolic Higher?

Let say it is our view that TSLA is going to $300 by expiration. The trade on the previous

slide will never net more that $1,500. Lets look at the results of simply buying the Jun 200

Calls for $15.00.

Maximum risk: $1,500 per 1 lot

Maximum Reward: Unlimited

If share of TSLA do move to $300 on expiration these calls will be worth $100 on

expiration. This trade would profit a total of $8,500 per 1 lot. As we can see this trade is

much more profitable that the covered call set up.

Covered Calls

What Makes Some Traders Avoid Covered Calls All Together?

Remember that when running a covered call the position is equivalent to a short put.

Short puts do carry higher levels of max risk and are more suitable for longer term traders.

As an active trader I prefer not to tie up capital in positions like these. I prefer to find

better reward to risk setups.

Lets break down the risk in an AAPL trade on the next slide.

Covered Calls

What Makes Some Traders Avoid Covered Calls All Together?

AAPL is trading $550 and I buy 100 shares of AAPL for $550 and sell 1 of the July 500 Calls

for $70.

Risk: $47,800 per 1 lot with Dividend.

Reward: $2200 per 1 lot

This is a huge amount of risk to take on for only $2,200 in potential profits. What if AAPL

stock falls to $100 by expiration? This trader will experience huge losses and could never

make more than $2,200 per 1 lot.

Covered Calls

Managing Covered Calls on Expiration:

Managing expiration is one of the most important things a trader can do.

Lets look at an example in TWTR:

TWTR is trading $62 and I buy 100 shares of TWTR at $62 and sell 1 of the June 60 Calls for

$10

On expiration there will be 3 levels I need to be aware of. Lets look at these scenarios on

the following slides…

Covered Calls

Level #1- Stock is trading between $0-$60 on June expiration:

The 60 Calls will be worthless and the trader will maintain their long stock position. After

expiration, a trader can choose to sell another call against their stock position an establish

a new position.

Level #2- Stock is trading between $59.95-$60.05.

In this region a trader is exposed to “pin risk” on their short call leg. As the option seller

we have no way of knowing if the buyer is going to exercise their call. I would buy the calls

back in the last 10 minutes of the trading session to eliminate pin risk.

Covered Calls

Level #3- Stock is trading above $60 on June expiration:

Our short call leg will become short stock and our position will net our completely flat

after expiration. This is also the level where this trade nets its maximum potential profit.

Understanding what is going to happen to your positions on expirations is very important.

By understanding how expiration works a trader will never be surprised by a residual stock

position as a result of expiration.

Covered Calls

Summary:

- The strategy can be used to create an extra dividend stream

for long stock and also gives the owner some downside

cushion.

- Trader doesn’t have to sell ATM calls, can sell OTM calls for

less premium while giving the stock more room to rise.

- Strategy works best when expecting a slow move upwards or

neutral in the stock until the option expiry.

- This strategy is equivalent to a synthetic short put.

- If the trader sells out their underlying stock position they are

left naked short calls. Remember, short calls have blowout risk.

- Understand how to manage expiration and you will never have

a residual stock position.

- Consider if a covered call is the best way to express your view

on the future movements in an underlying stock. Often there

are better ways to profit on stocks you expect large upside

moves in.