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The Covered Call Option Strategy can produce income from stocks you own, or reduce your purchase price on stocks you buy.

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Strategy: Covered Call, OTM

a.k.a. Buy-Write

Covered Call Out of the Money Option Graph

The Outlook: mildly bullish. The stock must stay above your purchase price, less the premium received. But if the stock rises too much, you miss out on gains beyond the strike price.

The Trade: buy stock, sell call(s), using a strike price above the current stock price.

Gains when: stock stays over purchase price less premium received.

Maximum Gain: strike price - stock purchase price + premium received.

Loses when: stock falls more than the premium received.

Maximum Loss : unlimited.

Breakeven Calculation: Stock purchase price - premium received.

Advantages compared to stock: slightly less capital required, some downside protection.

Disadvantages compared to stock: cannot participate in gains beyond the strike price sold.

Volatility: after entry, decreasing implied volatility is positive.

Time: after entry, the passage of time is positive.

Margin Requirement: None for the short calls. Unless you have permission from your broker for "naked" call selling, you must maintain the stock position as long as you are short the calls. The stock is what makes the short calls "covered".

Variations: Covered Call, ITM; Covered Call; ATM.

Synthetic Equivalent: Selling a Put at the same strike.

Comments

  • Covered Calls can be used if you want to make some income on a stock that you are determined to hold for the long term, but believe is going nowhere in the short term.
  • Any stock that has options can be converted to a covered call at any time. If you buy stock and sell options in the same transaction, the strategy is termed a "buy-write". After you are in the position, covered calls and buy-writes are the same thing.
  • Stock investors should understand what selling calls represents: they are selling the right to buy their stock at the strike price of the calls they sold. If this represents a good gain on the stock, that can be a good outcome. If the strike price sold represents a loss on the stock, or they do not want to be called out of their stock, then it can be very expensive to buy back the sold calls to avoid assignment.
  • See the Covered Call Strategies Disadvantages for information concerning the possible pitfalls of the Covered Call strategy.

Exits

  • Since this is a mildly bullish position, the trader is expecting the stock to rise somewhat. If the stock falls instead, the premium brought in will give a slight "downside protection", but cannot make up for a large loss in the stock. If the stock falls by more than the premium brought in, the safest course of action is to close out the entire position.
  • If the stock rises, but not over the strike price sold, you should continue to hold the position. You will not realize the maximum gain on the premium you sold until after the option expires worthless. At that time you can sell the stock if you wish, or continue to hold the stock and sell more calls using the next expiration.
  • If the stock rises over the strike you sold, it is possible you will be "called out" of your stock at any time: someone could exercise calls that they bought. If you do not want to risk being called out, you need to either buy the calls back, or roll them forward or up, as in the Adjustments.

Adjustments

  • A common recommendation is to roll the short calls when they have lost 80% of their value due to time decay. This recommendation is actually trying to catch the point in time when the near term calls have lost most of their value, but the far term calls are not losing their value as quickly. If you wait longer so the near term calls lose all their value, then the longer term calls will probably have lost about as much.
  • Another rule of thumb that usually amounts to about the same thing is to roll when there is just a week left to expiration on the near term calls. At that time, the calls expiring the next month out will have about five weeks to their expiration, and will still have decent premium for the sale.
  • Rolling the calls means to buy back the near month calls you are short, and sell calls further out in time. The new calls you sell do not need to be the same strike price. If your stock has moved up, you can sell a higher strike price.
  • Rolling is a type of spread trade, and most brokers give a commission discount for spread trades. A spread trade means you buy options and sell options in one transaction. You can also roll by entering two separate trades, but you will be charged two commissions.

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