Order Entry: Credit
Ideal Environment: High IV
Profit Target: 50%
Definition: A covered call consists of selling an OTM call against a long stock position. Each call sold has to be against 100 shares of stock to be considered “covered”. The premium collected lowers the cost basis of the long stock position. Covered calls limit upside profitability, but increase the probability of success.
Covered Call Setup
Buy 100 shares of stock
Sell 1 call for every 100 shares of stock (either ATM or OTM)
Stock Price goes above Strike Price
The buyer has the right to exercise that option. Once the option is exercised, the call seller is required to sell 100 shares per call at the specified strike price. In the case of a covered call, the call seller already owns the shares.
In this situation, the trade is closed out at max profit once the shares are called away.
Max Profit = ((Strike Price - Stock Price) X Number of Shares) + Call Premium.
Although the trade is profitable this situation shows one downside to covered calls. If the trader was only long stock, their profit potential is not limited.
Stock Price goes up, but stays below Strike Price
In this scenario the call is going to expire worthless if the stock price does not pass the strike price. The profit is a combination of stock appreciation (paper profits) along with the sale of the call.
Profit = ((Current Stock Price – Purchased Stock Price) X Number of Shares) + Call Premium.
The upside to selling covered calls is the seller doesn’t have to give up their stock position, if the stock price doesn’t go above the strike price. Therefore, they could put on the same trade after the call option expires or is bought back.
Stock Price goes down from original purchase
Once again, the call is going to expire worthless. The risk of covered calls is that the stock price has gone down enough to outweigh the amount collected for selling the call. The loss starts once the stock price falls below the purchase price minus the premium collected.
Loss = ((Current Stock Price – Purchased Stock Price) X Number of Shares) + Call Premium.
Stock Price plummets to $0
The worst possible situation for a covered call trade is if the stock goes to $0. Of course this doesn’t happen often, but there is the possibility. With this situation, the trader keeps the premium from selling the call and loses the principal on buying the stock.
Max Loss = (($0 – Purchased Stock Price) X Number of Shares) + Call Premium.
When to use a covered call strategy?
At Tradezy, we recommend to use this strategy with low priced stocks with high volatility. The trader should have a short to intermediate bullish thesis. We look to sell an OTM call against a long stock position that has around 45 DTE with a 70% chance of expiring worthless.