Covered Calls EXPLAINED (Options Trading Strategy Tutorial)

the covert call option strategy is a great strategy for existing stock market investors because the covered call strategy reduces the loss potential on the shares of stock that you're holding it can create a stream of revenue each month should the stock price not increase too significantly it increases the probability of making money while holding shares of stock and lastly the covered call strategy is very easy to execute which we'll talk about in just a moment in this video I'm gonna visually explain to you exactly how the covered call option strategy works we're gonna walk through historical trade examples so you can see how the strategy makes and loses money in real historical stock market scenarios and lastly I'm gonna show you exactly how to set up a covered call using real brokerage software so be sure to stay tuned because all that's coming up right now now really quickly if you're brand new to the channel be sure to subscribe and enable notifications so that you can get notified whenever I upload new options trading videos the cover call option strategy is very popular among long-term stock investors because it can reduce the lost potential on the shares it can create a stream of income on those shares so long as the stock price does not increase too significantly and lastly the strategy is very easy to execute and follow let's start by talking about the two components of the covered call option strategy the covered call option strategy consists of two components the first being owning at least a hundred shares of any stock and the second component is selling a call option against the shares of stock that you own to be clear you have to have at least 100 shares of stock for every one call option that you sell for it to be a true covered call position selling a call option all by itself without owning any shares of stock is an incredibly risky strategy because call options increase in value as the share price continues to increase because the ability to purchase shares of stock at the call options strike price becomes more and more valuable as the share price appreciates since there's no limit to how much a stock's price can increase there's also no limit to how much a call option on that particular stock can depreciate you so let's look at an example to show you what I mean as an example let's say we have a 250 dollar stock and a trader sells the 275 call option for 5 dollars in premium which means they're selling the call option with a strike price of 2 and $75 and they're collecting $5 for selling that option now let's say that option expires in 30 days if some news came out and the stock price increased from 250 to 350 dollars over that time period that 275 call option is going to be worth at least $75 because the stock price at 350 dollars is now $75 above the college strike price and a call option will always be worth at least its intrinsic value which is the difference between the stock price and the calls strike price if a trader sells a call option for $5.00 and the call option appreciates to $75 that equates to a loss of seven thousand dollars just for one call option that was sold and if you have more contracts that loss scales up with the number of contracts so all by itself selling a call option is a highly risky strategy because there's no limit to how much a stock's price can increase and since call options increase in value as the share price also increases there is no limit to how much a call options value can increase to which makes selling a call option all by itself an extremely risky strategy now when combined with owning a hundred shares of stock selling a call option is not risky at all because with a hundred shares of stock already in your possession if the stock price does increase significantly above that the calls strike price you as the call seller will just have the obligation to sell your shares of stock at the collège strike price and you'll also keep the premium that you collected when selling that call option so getting back to our previous example if a trader owned a hundred shares of the stock that was initially trading for two hundred and fifty dollars and they sold the 275 call option for five dollars in premium that means that the trader is accepting the fact that if the stock price is above 275 at expiration they will have to sell their hundred shares of stock for 275 dollars per share but they will also keep the premium that they collected for selling the call option so in our example if the trader bought a hundred shares of stock for 250 dollars and they sold the 275 call option for five dollars in premium if the stock price increased to 350 dollars that treater would have to sell their shares of stock at the college strike price of 275 dollars which would realize a gain of $25 per share and on a hundred shares that would be a gain of $2,500 now since the trader also called did five dollars in premium for selling the 275 call option they would keep that as well if they hold the trade through expiration and that means the total trade profit would be three thousand dollars twenty five hundred of which coming from the appreciation of the shares and five hundred dollars of that profit coming from the option that they sold initially in short by selling a call option against a hundred shares of stock you are collecting option premium in exchange for giving up the upside at any price above that calls strike price so in our previous example the trader is buying a hundred shares of stock for $250 a share and they were selling the 275 call for five dollars of premium now that essentially means that the trader is accepting 500 dollars in premium in exchange for forfeiting any gains in the stock above 275 dollars which is the calls strike price so this particular trader would only do this trade if they believe that the stock that they're trading or holding would not appreciate to a price above the college strike price at expiration because ideally a covered call trader keeps all of the profits from the call that they sell which would occur if the stock price remains below the strike price and ideally they want to keep holding their shares in the future so that they can sell another call option once the current call option expires and they have that profit in their account in our previous example you may have noticed that if the call option was not sold the profit on the position would have been $10,000 because if the investor buys a hundred shares of stock for 250 dollars and the share price goes up to 350 dollars they have a 100 dollar gain per share and on a hundred shares the total gain is 10,000 dollars so this brings up the big downside of trading cover calls which is that when you sell a call option against a hundred shares of stock you are essentially accepting the option premium in exchange for any upside above the call options strike price that you sell so in our example where we bought a hundred shares of stock for 250 dollars a share and sold the 275 call option for five dollars we're collecting five dollars in exchange for giving up any upside on the shares above 275 dollars so with that being said investors who are extremely bullish on their stock that they're holding may not want to sell call options against their shares of stock at all because as I just mentioned by selling a call option you are giving up any game on the shares at any price above the call options strike price and if you think the stock price is going to increase significantly in the near future then selling a call option in exchange for all the upside above that call options strike price doesn't make any sense let's move on and visualize a hypothetical covered call position and compare it to just holding a hundred shares of stock so you can clearly see the differences between just holding a hundred shares of stock and selling a call option against those shares to create a covered call position so for this example let's assume I buy a hundred shares of stock for $75 a share which is a $7,500 investment then to create a covered call position I sell the call option with a strike price of $80 for $3 in premium and let's say this call option with a strike price of $80 is expiring in 30 days now keep in mind that if I'm collecting $3 for an option that actually means I'm collecting $300 an option premium because every standard stock option corresponds to 100 shares of stock so when you look at a option price of $3 that options value is actually $300 in short I'm buying a hundred shares of stock at $75 a share which is a $7,500 investment and I'm selling the thirty-day 80 strike call option for $300 in premium let's take a look at the expiration payoff graph for this particular covered call position compared to the payoff graph of simply holding a hundred shares of stock purchased at $75 per share the first thing to notice about this graph is that the break-even price of the covered call position is $72 which is $3 below the share purchase price of $75 per share that's because if I purchase a hundred shares of stock for $75 per share and I sell a call option against those shares and collect three dollars in premium my effective purchase price of those shares is essentially decreased by the amount of premium I collected for selling that option a covered calls breakeven price is equal to the share purchase price less the premium received for the call option that you sell by selling a call option against your shares of stock you actually create some downside protection for your shares of stock which is one reason the covered call position is so popular the break-even price of $72 makes sense because at expiration if the stock price is at $72 on hundred shares of stock my loss on those shares would be $300 since I've lost $3.00 per share and own a hundred shares but since I sold that 80 call option for $3.00 if the stock price is at $72 when that option expires that call options value will be zero dollars because call options with strike prices above the stock price have no value at expiration and if I sold that option for $3.00 that means my profit would be three dollars and in actual profit terms that would be $300 since every option contract corresponds to 100 shares of stock if the stock price is at $72 I'll have a $300 loss on my share position but I'll have a $300 gain on the option portion of the position and that results in zero dollars in profits and losses which means I breakeven on the trade now if we compare the profit and loss levels of the 100 share position and the covered call position we can see that the covered call position will outperform the long share position by itself at almost every single stock price because by collecting option premium from selling that call option that call option premium either reduces our loss potential or increases our profit potential at almost every single stock price as I mentioned earlier the big downside of trading covered call positions is that you give up any upside on the shares at any price above the strike price of the call that you sell the benefit of having enhanced profitability and reduced loss potential at most stock prices comes at the cost of giving up all of your unlimited profit potential above the calls strike price if the stock price is above the short college strike price at expiration the covered call trader has two choices the first choice is to allow the option to expire in the money and that would mean that they would effectively sell their shares of stock at the college strike price because if you hold a call option through expiration and that call option has value at expiration that call option will automatically be exercised which means anyone who owns that option will buy a hundred shares of stock at the college strike price and on the other side of that it means that anyone who is short that call option such as a covered call trader will effectively sell a hundred shares of stock at the college strike price the second choice a covered call trader has an expiration if the stock price is of of the college strike price is to buy back the short call option for whatever price it's currently trading for that's the only way to keep your shares of stock if you are a covered call trader because as I mentioned earlier if the stock price is above the college strike price and you hold that position through expiration that call option will automatically be exercised which means you as the option seller will be assigned on that short call option which means you will sell a hundred shares of stock at the college strike price so if you are adamant about keeping your shares of stock and you do not want to sell them you will have to buy back the call option at expiration for whatever price it's currently trading for which likely means you'll be taking a loss on the call portion of that trade if you are buying back that call option at a price higher than you sold it for but even in that scenario you will still have a profit on the overall covered call position before we move on to analyzing historical covered call positions I'm gonna hop over to the tasty work straighting platform and show you exactly how to setup a covered call position so I just opened up the tasty works trading platform and I'm currently looking at Apple options in the middle here so we have all the option expiration cycles for Apple now as of this recording Apple is trading around two hundred and four dollars and thirty cents and the first component of a covered call position as we know is buying 100 shares of stock now to do that on the taste Oryx trading platform all I have to do is click on the ask price and if I do that we can see on the bottom here it queues up in order to buy a hundred shares of Apple stock at two hundred and four dollars and 28 cents which is the mid price between the bid and ask price so the bid price being 204 18 the ask price being 204 38 the halfway point between that is 204 28 the first thing I want you to notice is that the maximum profit potential is theoretically unlimited which is designated right here by this little infinity symbol and that's because since there's no limit to how much Apple's stock price can increase to there's theoretically no limit to the profit potential on this position the maximum loss potential is twenty thousand four hundred and twenty-eight dollars which stems from the fact that if I buy a hundred shares of Apple at 2:04 twenty eight per share the maximum loss is two hundred and four dollars and twenty eight cents per share and on a hundred shares the some lost potential would be twenty thousand four hundred and twenty-eight dollars we can actually visualize the profit and loss potential of this position by clicking on the curve and making sure analysis is checked the profit and loss graph is very linear because since we're buying 100 shares of stock for every $1 increase in Apple stock price this position will profit by $100 and for every $1 decrease in Apple stock price this position will lose $100 now if I go back to the table view we know that we have to sell a call option to create a covered call position so I'm gonna open up the June 2019 options and let's say I want to sell this 210 call option for around five dollars in premium to do that I can just go ahead and click on the bid price of 495 and this cues up in order to sell the 210 call option at the mid price which is between 495 and 5 dollars and 10 cents now at the bottom here we can see that the mid price of this overall position so buying the shares at the mid price and selling this call option at the mid-price gives us a mid price of 199 26 and the first thing I want you to notice is that the maximum profit potential is now defined to 1074 dollars and the maximum loss potential has actually decreased to 19 thousand nine hundred and twenty six dollars and that's because if I sell this call option collecting about five hundred dollars in premium the loss potential on buying 100 shares of stock is decreased by about five hundred dollars now the maximum profit potential of 1074 dollars comes from the fact that if I buy this position for a total cost of 199 26 the most I can make is going to be if Apple goes to 210 dollars or more in which case I'll have to sell my hundred shares of Apple stock at 210 dollars per share and if I buy this position for 199 26 and it appreciates to a valuation of 210 dollars the profit will be 1074 dollars for 10 dollars and 74 cents per share so essentially you just have to take the call strike price of 210 dollars less the cost of the position at entry which is 199 26 and the difference between these numbers is 10 dollars and 74 cents so basically if I buy a hundred shares of Apple stock and sell this call option my effective purchase price of the shares will be 199 26 and the highest price I can sell these shares for since I sold the 210 call option would be two hundred and ten dollars so at any price above two hundred and ten dollars my profit on this position will be one thousand and seventy four dollars and we can visualize that once more by clicking on the curve view and analyzing this positions profitability as we can see here at any price above two hundred and ten dollars the profit at expiration is one thousand and seventy four dollars since I have to sell 100 shares of Apple stock at two hundred and ten dollars per share if Apple is above the college strike price of 210 at expiration as we can see here the break-even price is actually below the current Apple stock price of around two hundred and four dollars and thirty cents and that's because if I buy this position for a total cost of $1.99 26 that means my breakeven price is 199 26 as we can see here now that I've just shown you how to set up a cover call using real brokerage software let's go look at some historical covered call trade examples so you can see exactly how a covered call might perform in various scenarios keep in mind that in these upcoming examples the specific stock does not matter at all because the general concepts will carry over to other covered call positions on other stocks the important thing to understand is how these covered call positions performed and why in this first example we're gonna look at a scenario where the covered call position does not make as much money as simply buying and holding a hundred shares of stock here are the historical trade details for this first example at the time of entering the trade the stock price was at a hundred and twenty one dollars and forty-five cents and to set up the cover composition he purchased a hundred shares of stock for a hundred and twenty one dollars and forty-five cents to complete the cover call position I sold the 125 call option for one dollar and forty one cents and that option had 74 days to expiration the maximum profit on this particular covered call position is 496 dollars which can be calculated by taking the difference between the kalos strike price of 125 the Sherriff purchase price of a hundred and twenty one dollars and forty-five cents and adding the call premium to it which is one dollar and forty one cents the expiration break-even price of this position is the share purchase price of a hundred and twenty one dollars and forty-five cents less the credit we received from the call option which is one dollar and forty one cents and if I take 120 145 which is the share purchase price and subtract the call premium of one dollar and forty one cents we get a breakeven price of one hundred and twenty dollars and four cents let's take a look at how this trade performed as we can see the stock price increased substantially over the first month rising to a price of a hundred and thirty-four dollars per share at approximately thirty five days to expiration with the stock price at one hundred and thirty-four dollars the profit on the covered call position was right around five hundred dollars which essentially means the covered call position was already trading at the maximum profit potential since we know that the maximum profit potential of this covered call position was four hundred and ninety six dollars based on our calculations earlier the position of just holding a hundred shares of stock had a profit of around twelve hundred and fifty dollars and that's because without the call option sold against those shares the position of owning a hundred shares of stock has unlimited profit potential in theory because that position will get more and more valuable with every increase in the share price since there's no call options sold against those shares in this example since the stock price increased to a value much higher than the calls strike price of 125 dollars the covered call position underperformed in terms of profitability relative to just buying and holding a hundred shares of stock and this example highlights the downside of trade in covered calls which is if the stock price increases significantly and is above the called strike price at expiration that covered call position will underperform the profitability of just buying and holding 100 shares of stock in this next example we're going to look at a scenario where the stock price did not change much over the entire trade duration which means that the covered call positions profitability is going to be much higher than simply holding a hundred shares of stock because when you buy and hold a hundred shares of stock if the stock price does not increase you will not make any money whereas with a covered call you still have that short call portion of the trade and if the stock price doesn't increase you will have profits that stem from selling that call option while you have no profits from your share position itself so here are the trade details first the stock price at entry is a hundred and sixteen dollars and forty-five cents which means we purchased a hundred shares of stock for a hundred and sixteen dollars and forty-five cents to complete the covered call position we sold the 120 call option for five dollars and 80 cents and that call option had 53 days to expiration at the time of purchasing the shares of stock this particular covered call position had a maximum profit of nine hundred and thirty five dollars which is calculated by taking the difference between the called strike price and the share purchase price plus the call premium that we received at the time of entering the trade the expiration break-even price of this covered call position is a hundred and ten dollars and sixty five cents which comes from the share purchase price of one hundred and sixteen dollars and forty-five cents less the call premium received of five dollars and eighty cents let's take a look at how the two strategies performed side by side the main point to get across in this particular example is that the stock price ended very close to the price where it began which means simply buying and holding a hundred shares of stock would have virtually no profits or losses but in this example since we did have a covered call that collected five dollars and 80 cents in premium for selling the call option we can see that the covered call position actually had a profit of around five hundred and eighty dollars at expiration and that's because at expiration if the stock price is below the college strike price that call option will expire worthless and if I sell a call option for five dollars and 80 cents in premium I'm actually collecting five hundred and eighty dollars and if that option price goes to zero then my profit on that option trade will be five hundred and eighty dollars this is really the ideal scenario that you encounter when trading a covered call as you can experience profits on holding shares of stock at no additional risk and if the stock price just trades flat over the time that you have that call option in your portfolio your covered call position will still profit even though the share position itself is not profiting at all because since you've sold that call option and the stock price is not increasing that call options value will steadily decrease as it's expert date approaches and that will generate profits for you as an options trader now that we've gone over multiple cover call examples and I've shown you how the strategy works how does one go about selecting a specific call option to sell when trading a covered call position choosing which call options to sell as part of a covered call position depends on your particular outlook for that stock and over a specified time period now in terms of the number of days to expiration on the option that you're selling the most common time period would be somewhere between 30 and 60 days to expiration since if you sell an option with 90 days or 120 days to expiration those options are going to experience a much slower rate of decay relative to a 30 or 60 day option because options decay more and more as they approach their expiration dates another benefit of selling a call option with 30 to 60 days to expiration is that you'll be able to readjust your stock price outlook and your called strike price more often than you would if you would have sold a call option with 150 days or more to expiration the amount of premium collected for selling that particular call option should also play a role in determining whether or not it's even worth it to treat a covered call position as opposed to just continuing to hold a hundred shares of stock because if you look at a call option that you want to sell and you're only collecting 50 cents and you're giving up all your upside above that called strike price maybe that premium of 50 Cent's doesn't justify the fact that you're giving up the share upside and in that case you just hold your shares of stock and choose to not sell they call against those shares now to quickly demonstrate what I mean by all of this I'm gonna hop over to the tasty works trading platform once more and we're gonna analyze different call options that could be sold for a particular covered call position and we're gonna weigh the pros and cons of each of those call options that we could potentially sell so getting back to our Apple cover call example from earlier if I purchase a hundred shares of stock of Apple for 204 dollars and 28 cents the next thing I have to do to create a covered call position is choose a call option to sell as I just mentioned selling a call option is a balancing act between the amount of premium that you want to collect or the amount of downside protection that you want the likelihood that you're gonna have to sell your shares of stock if the stock price is above the calls strike price at expiration one thing that I could do which would be the most aggressive covered call position is to sell the 205 call option for around $7.25 in premium so if I do that we can see that my maximum loss potential is 19 thousand seven hundred and three dollars and my maximum profit potential is seven hundred and ninety seven dollars and that's because if I sell this 205 call option there's really only 70 cents for Apple to increase before my profitability on the share position is capped but I will still profit from the premium collected from the call option which is why this maximum profit is around eight hundred dollars so in this scenario since Apple only has to increase about 70 cents before it's above my calls strike price I will collect the most amount of premium for selling this call option but I also have the highest likelihood of having to sell my Apple stock at expiration because there's a very high likelihood that Apple could be above two hundred and five dollars at expiration in 55 days now let's say I did not want to sell my Apple stock and I wanted to keep the shares in which case I would have to sell a higher strike call option such as the 215 call option but if I sell the 215 call option you'll notice that I only collect about three dollars and thirty cents in premium as opposed to around $7.25 in premium so in this scenario we can see that my maximum profit is fourteen hundred and four dollars but my maximum loss potential is twenty thousand ninety six dollars so by selling a higher strike call option and collecting less premium I will have more profit potential because there's more distance between the current stock price and the college strike price which means I have more profit potential on the share position but by selling this 215 call option as opposed to the 205 call option I collect less premium overall which means I have less downside protection should Apple stock decrease and we can see that by looking at the maximum loss potential of twenty thousand and ninety six dollars compared to the maximum loss potential of nineteen thousand seven hundred and three dollars if I were to sell the 205 call option so in short when choosing a call option to sell you really have to figure out how much you want to keep your shares of stock because if you really want to keep the shares of stock you're probably going to want to sell a call option at a higher strike price but you also don't want to go to too high of a strike price because if you go to too high of a strike price as we can see here the premium that you collect for selling that call option gets very very low which means selling the call option becomes less advantageous for you as a covered call trader the last thing that you have to keep in mind before selling a call option against your hundred shares of stock is that if the stock price is above the called strike price at expiration you could be in a scenario where you have to sell your shares of stock so if you're in a position where you want to keep your shares of stock and you do not want to sell them but you still want to implement a covered call position then you're gonna have to choose a higher strike price that has a lower probability of being in the money at expiration now if you don't care so much about selling your shares of stock and you want more downside protection then you can sell a call option with a lower strike price in which case you'll collect more premium and have more downside protection on your shares but that comes at the cost of having a higher likelihood of having to sell your shares since your call option strike price is closer to the stock price and smaller stock price increases are more likely than larger stock price increases in other words deciding which call to sell is a balancing act between how much downside protection you want or how much premium you want to collect for selling that option and how likely you are to sell your shares of stock at the college strike price to wrap up this video I'm going to go through a couple frequently asked questions regarding covered calls the first question is can you trade a covered call position with more than a hundred shares of stock and the answer is yes as long as you have a hundred shares of stock you can sell one call option against your shares of stock and you don't necessarily have to cover all of your shares of stock that you own for example if you have 350 shares of a stock and you sell two call options against those 350 shares only 200 of those shares will be covered calls and the additional 150 shares that you own will we'll be uncapped and still have the unlimited profit potential because those 150 shares do not have a call option sold against them a second frequently asked question is do you have to hold a covered call position through expiration or can the covered call position be closed early prior to expiration the answer is that any option or stock position can be closed at any time you just have to pay whatever the current price is for that strategy so for instance if you wanted to close your covered call at any moment what you would have to do is sell your hundred shares of stock and buy back the short call option at the same time which would effectively close your covered call position and at that moment your profit or loss would be dependent on how much you sold your shares for and how much you paid to buy back the option but you don't have to close the entire covered call position because if you just wanted to close the call portion of the position all you'd have to do is buy back the short call option at whatever price it's currently trading for in the market in which case you would realize a profit or loss depending on how much you paid to buy back that short call option but you would still have your shares of stock the next question is is there any way to avoid being assigned on that short call option if it is in the money the answer to this is no if you sell an option and the option is in the money you have no control over when someone exercises that option and since you have no control over when someone exercises that option you have no control over when you are assigned on that option the good news is that options with lots of extrinsic value are very unlikely to be exercised because any trader who exercises an option with lots of extrinsic value will lose a hundred percent of the extrinsic value that was in the option when they exercised that option the only way to truly avoid being assigned on a short option that is in the money is to buy back that option and close it all together but as I just mentioned as long as the option has lots of extrinsic value remaining that option is not likely at all to be exercised which means you as the option seller have a very low probability of being assigned on that option please give this video a like if you enjoyed it and feel free to leave a comment down below because believe it or not I do answer almost every single comment that is left on my videos so if you have a question about this video drop a comment down below and I will answer you as soon as possible that's going to do it for this video covered calls everybody I really hope you enjoyed this video and learn something from it once again I'm Chris from project option and I will see you in the next video [Music] [Music]

Channel: projectfinance

Views: 291,746

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Keywords: covered call, covered call options strategy, covered calls for income, covered call writing, covered calls explained, selling covered calls, covered calls for beginners, options trading, options strategies, call option, stock market, option strategies, stock options, options trading for beginners, writing covered calls, projectoption, tastyworks, tastyworks trading platform, how to setup covered call tastyworks trading platform, finance, tastytrade, how to trade

Id: 1gXlr18gWSY

Length: 31min 30sec (1890 seconds)

Published: Wed May 01 2019