Covered Calls are the Trading Cheat Code | How to Trade Covered Calls

this poker chip represents a single share of a company and here are 100 shares of that company well let's say you decide that their business model seems pretty solid so you buy those hundred shares for 20 bucks great these shares are now yours and in fact most people would probably be done here but you don't have to be instead you can capitalize on owning these hundred shares and sell a call against them that means writing a call option creating an entirely new contract and selling it for cold hard cash that money is now yours and you can spend it however you want well there's two possibilities after this point one is that the call option expires out of the money you keep your premium you keep your shares you're just a little better off than when you started the second possible outcome is that the stock price rises assuming you sold out of the money option and it expires in-the-money the call option buyer then exercises that option buying 100 shares at the strike price sure you do lose your shares but you get to keep the premium for selling the call and you also make money for selling those shares at a higher price and you bottom four I don't think that analogy is gonna carry you through to actually trading these suckers so let's go into more detail on how they work the pros and cons and all that jazz and then we'll do a trade on thinkorswim which is TD Ameritrade trading platform so you guys can actually see how they work in real life as well all right let's start building our covered call position here so the first step is buying 100 shares so here we have 100 shares of AMD now what we're gonna use these hundred shares as is collateral to write a call now if you're not familiar with writing calls or even what that means I'm not surprised because most people spend a lot of time just buying calls and puts riding a call is selling a call you don't already own this creates an entirely new contract and it sells it to somebody else so what is your obligation as a seller well if you think about when you buy a call you get the right to exercise it meaning you buy 100 shares at the strike price so when you sell a call to somebody you have to provide those hundred shares if they decide to exercise if that call gets in the money and your counterparty exercises you have to fork up those hundred shares and toss into their lap and that's why we have these hundred shares here and it'll kind of makes sense as we keep going so let's say we sell a call it's strike is 55 so it's an out of the money call you see 50 Cent's premium and credit that credit you get to keep because you don't ever have to buy back to closest position either it expires out of the money and you would keep the credit anyway or it expires in-the-money you get assigned meaning that your counterparty exercises and those hundred shares get called away from you and go to the buyer of the option but either way whether you get assigned meaning the buyer exercises or if this call expires out of the money either way you get to keep that 50 cent credit now you could buy to close this position but that's not really the point of a covered call so when you sell this and you give that 50 bucks you can do whatever you want with it you have that 50 bucks now that's really cool you can make money off of the hundred shares you already own just by selling a call against it and you could withdraw it and buy packet beer if you want that's basically it that's basically a covered call but let's walk through in more detail the benefits and risks of this kind of trade so let's draw out a little stock graph stock chart here this is AMD so we'll say it starts out like this so we buy a hundred shares at 50 and we sell a call with a strike of 55 let's think about our possible outcomes the first outcome is that the stock price goes down as the stock price goes down and we hit our expiration day let's say expiration is right here this call expires out of the money it no longer exists that premium stays in your pocket the trades over you still have your hundred shares the only thing that's changed is that you've collected $50 which has really overall reduced the cost of these hundred shares so if we bought a hundred at 50 what we paid is $5,000 for this shares but since we made $50 from selling this column we get to subtract that and now the cost of these shares really is more like four thousand nine hundred and fifty so we've reduced what's called our cost basis and made these shares cheaper of course we're still incurring losses owning a hundred shares and writing this just waved down is going to overall incur some losses our Delta is positive still so if the stock price goes down we are losing money but we're going to lose money anyway for a happy holding this is a long-term position we've only reduced our losses and reduced the cost of our shares so that's one possible the second outcome is that the stock price rises and it goes above our strike and our call expires in-the-money so if our call expires in-the-money we have to sell 100 shares at the strike price so if the strike is 55 we have to sell 100 at 55 but if we bought 100 at 50 we make a net gain of $500 so let's write it out here we bought 100 shares at 50 $50 per share then we sold 100 shares because we were assigned at expiration day because I call this in the money at the strike price of 55 so really we are long five thousand dollars worth of stock but then we get to sell that for fifty five hundred dollars so this would be a debit and then in credit so we get a net credit of five hundred dollars so we still made money on the trade but not only that we also got to keep our credit that doesn't disappear you sold that option it stays in your pocket regardless of if the person exercises or whatever whatever happens as long as you don't buy to close that call you get to keep that credit so yeah we make five hundred dollars but we also make fifty dollars on top of that so we make five hundred and fifty dollars so what's the downside here Adam well in our first example you know the stock price went down if you don't like holding this underlying stock that's gonna stink if you don't believe that's gonna rise in the future again in the long term that's gonna stink holding one hundred shares as things go down but if you're comfortable holding them you're gonna make fifty bucks just selling a call against it if you're gonna hold it for the long term anyway so no downside there really if you're comfortable holding for the long term in this example where our call expires in-the-money what's the downside here the only downside is that we miss out on this extra return since we have to sell it at 55 maybe the stock price went all the way up to 60 at expiration we miss out on that extra $5 and we lose those chairs these hundred shares get called away we have a flat position here so we have zero shares but we made $550 it's a big zero deal it's a fat goose egg so if you really really really wanted to hold those shares then you're gonna be kind of bummed about that you missed out on some opportunity for capital gains because things would higher than your strike and that's why when you open a covered call position wherever you sell the call at you need to be comfortable letting that call your shares go at that strike price but at the end of things either way you're making money basically sure in the last example you would technically lose money because the stock price depreciate some value but if you're gonna hold it for the long term anyway you don't really care so you made 50 bucks on top of it just by just for owning those hundred shares in this case sure things went above your strike and you maybe missed out on some capital gains but you still made $550 which is not a loss so to summarize our two outcomes are the call expires out of the money you get to keep your shares and the credit our other option is their call expires in-the-money we lose our shares but we gonna make the difference between these two prices which was our $500 plus the credit received so both ways if you're comfortable holding for the long term and comfortable selling at your strike regardless of what way the stock price goes then it's kind of a win-win situation this is a sketch of what your profit and loss would look like as a profit loss diagram so you lose money if things go all the way down you make money as things go up but you stop making money once the stock price passes your strike so remember on the x-axis we have the stock price on the y-axis we have profit and loss if things go past your strike that's when your profits stop because you're gonna have to sell those shares at the strike now you could buy to close your call but it can get kind of expensive so generally you want to make sure that you're comfortable selling those shares at the strike price now how do you saya decide which strike to sell at well it kind of depends on how badly you want to keep the shares and how much premium you want to receive so if you really like holding AMD you can sell it pretty far out of the money call that's very unlikely to get in the money and therefore unlikely for you to get an assigned but you're gonna receive a smaller premium because the further out of the money the less those options are worth you know if you don't really mind if you don't really want to hold the shares that badly like you're okay letting go a little at a price a little bit lower well you can use it as a way to exit your position by selling a call that's a little closer to round at the money and if things go down and you're okay with that well you get to keep the larger premium the larger credit because he sold a call that was worth more so it's pretty subjective as long as you're okay with holding the shares for the longer term and you're also okay with the potential of having to sell this year to the strike price then your Gucci there's nothing that can really hurt yet there's no surprise oh and one more thing about this this year graph this is all at expiration so before expiration if the stock price is going up like this past your strike you're gonna see that your call is losing a ton of money like you'll see it shows that your profit losses is pretty pretty hurty but once that call expires and it gets assigned all that really ends up happening is you stopped making money past your strike so if you see that your call is losing a ton of money don't panic that's fine at expiration it's going to get assigned if it's in the money Roger got it cool all right let's run through an example on thicker swim so we're on thinkorswim and we're gonna use their on-demand feature which allows us to trade in the past which is pretty neat and I know there are platforms kind of sand paper and eyeballs but if you get used to it it has a lot of cool features plus TD Ameritrade has a bunch of free educational content on their website and you can access it by just creating an account with them I found it really helpful you can learn about futures fundamentals options all sorts of different stuff and a little quiz you and stuff like that and I found that the actual quality of the educational content is really solid I'm not sponsored by them I just I really appreciate what they're doing I think you guys might find that helpful okay so we're trading in the past here and we're trading on AMD again this is in March 1st 2018 back when AMD is trading at 1184 if I go over to the monitor tab this is where I see all my positions we have no positions I've reset this on-demand account so let's go ahead and buy 100 shares of AMD or quantities 100 up here we hit buy market we can send it off what are we buying it at we'll find out you're a second I guess so we bought 100 at 1185 now we want to sell a call against it let's say we think things are going down so let's sell a call against our 100 shares so we're gonna go over to the trade tab and I know this is just so hard to look at especially if you've never used this platform but I'm gonna try to direct your attention to the important stuff as best as possible so right here in the middle we have our strikes so 5 through 21 these are our strikes going down going up as we go down of course because why make trading easy and then our expiration is the 16th of March which is about you know a couple weeks away so let's say we think that we're let's go to the 4-hour chart here let's think that we see that the trend is changing let's say we think over the couple of weeks things are not gonna be looking so good maybe some by conductors are not doing well because of some news or whatever and we want to hide your position in solid covered call so we go to trade let's go ahead and sell we can sell a 13 strike for 19 bucks roughly 17 to 18 dollars which means that we don't expect the stock price to go past there now it goes past there we have to be comfortable letting go of our shares at $13 which is not gonna be that big of a deal because we got in a 1182 we make a dollar roughly dollar 20 on each of those hundred shares making roughly $120 if things bump on there so we still make money but if we're wanting to hold this for the long term best-case scenario is that we just had your position and we collect a credit on our long-term position so let's sell that 13 strike call and you can do this on Robin Hood too you do on any platform that the method is the same it's just the UI that looks different so we have our 13 strike call we're gonna click on sell make sure that we're just selling one and we want it to get filled immediately let's say so we're gonna sell it for the natural of 17 cents so we're gonna collect a 17 cent premium meaning we get $17 credited to our account and we get to keep that we go spin it if you want so we confirm and send there we go so now under this AMD we have both our hundred shares and our call that we sold so let's fast forward a little bit to the day of expiration and see how things are lookin so we're gonna pop forward to what does this expire March 16th okay so now we're on March 16th this is a dare option expires we are a couple hours away from closing vowel cuz I believe this is Pacific Standard Time so we've successfully stayed below the strike of the call we sold and fig over to monitor you can see we've collected quite a bit of money almost our entire premium of the call we sold we've collected $17.50 and we sold it for 18 cents so while overall you can see that our position you can see the profit loss open is minus 20 dollars we've lost $20 overall because the stock price has gone down from our entry point but we've negated some of those losses by collecting $17.50 of premium and now this call is going to expire worthless at the end of this trading day and you don't have to buy to close we don't have to give up our shares just earned 718 dollars against the shares we already owned so let's go ahead and fast forward to the opening bell of the following day and see that our option no longer is there and we're gonna be left for there hundred shares okay well this platform is saying that we still own it technically would have expired already you can see it has negative three days to expiration that's what days means right there so we have negative see it's just it's not processing it correctly but we've collected a credit against the shares we already owned now things popped up and we had to sell it at the strike they would be gone but we would still make a profit the difference between our entry point of the shares in the strike price of our call times 100 that's why covered calls are just so scrumptious like there's just like what what like you can't can't be mad if you're mad when you're trading covered calls you goofed it means you sold in the money call trying to correct collect a big credit but then had to sell the shares at a price lower than you bought them for him or if you didn't want to sell the shares of the strike at all no matter what the strike is and it becomes in the money and you want to buy to close the call you have to pay a big amount of money which would incur a loss to close that call then that's a problem but if you're comfortable holding shares as things go down or selling out the strike if things go up you can't lose thanks for watching guys if you have any questions about this let me know in the comments it me I'm the discord whatever I'm happy to answer questions about this have a lovely day thanks for watching I'll catch you in the next one [Music]

Channel: InTheMoney

Views: 687,411

Rating: 4.9567351 out of 5

Keywords: robinhood, think or swim, td ameritrade, webull

Id: jnTsQBJHMSk

Length: 14min 52sec (892 seconds)

Published: Thu Apr 30 2020

Reddit Comments

[u/frickshrek]

someone asked on another thread how this works so I copy and paste :)

Okay so best approach IMO is to write calls aka sell calls at a strike mark higher than your buy in price. You can go out as far as you want for expiration, the farther out the higher the premium you will receive.

When you sell the call you back it with your 100 shares as collateral and receive the premium.

A couple of examples/ scenarios:

say you buy 100 shares of XYZ at $10 your cost basis is $1000

now you sell a call at a price strike of $12 at a premium of $0.42 (remember when working with options it is always in 100's so premium for the contract at $0.42 equates to $0.42 per share x 100 = $42

subtract that $42 from your initial cost basis of $1000 = $ 958

your new cost basis is $958 now divide that by the total shares of 100 = $9.58

you have now effectively reduced your cost basis.

Now say the stock of XYZ goes up to $12 a share and the contract is exercised

Your initial cost basis of $1000 - the $42 premium = $958

when the contract is exercised at $12 a share you will receive $1200

now subtract your new cost basis $1200 - $958 = $242

you will have netted $242 in profit.

If the contract goes through expiration without hitting the price mark of $12 the contract expires worthless and you keep the $42 premium you collected from the call sell and you can rinse and repeat.

This will continually lower the cost basis of your holdings and/ or net you profit at a low risk.

I am not a financial advisor.