How to Manage Covered Calls (And Make More Money)

what's going on everybody chris here today is a big day because today we are talking about covered calls specifically how to go about managing covered calls which is a question that i get all the time from options traders around the world in this video i'm going to help you manage your covered call positions by going through some situational analysis using real option data from apple so i went back and looked at real covered call positions using real option data from apple and i created these nice visualizations that are going to help us understand the covered call position and go through some situations so we can learn how we could potentially manage covered calls better going forward i will also be talking about assessing early assignment risk as it relates to covered calls and we are going to visually assess when a covered call actually gets that early assignment risk point in this first situation we are going to look at a covered call position where the stock price is actually falling throughout the duration of the trade and this is perhaps the easiest covered call to manage as we'll see in just a minute in this trade we are buying 100 shares of stock at around 135 dollars per share and then to create the covered call we are going to short the 140 strike call option in the 39 day expiration cycle and we are going to collect three dollars and 25 cents for selling the 140 call so basically we take in 325 dollars of premium for shorting that 140 call against our 100 shares of stock that we purchased for right around 135 dollars per share so let's see what happened in the top portion of this graph we are looking at the changes in the stock price relative to that 140 short call that we entered as part of this covered call position and on the bottom portion of this graph we are looking at the profits and losses of each component of the covered call position so in this scenario the stock price is steadily falling from 135 dollars per share to around 125 dollars per share by the end of the trade and that means the short call is losing value steadily from the passage of time and the decreasing stock price over the duration of the trade and since that short call is losing value we actually see profits on the short call portion of the trade so this visual beautifully illustrates how the profits on the short call offset the losses on the stock position because as the stock price is falling we are going to see losses on the shares of stock that we own but we will see profits on the short call portion of the covered call trade and as that short call becomes more profitable we can see that the covered call profit and loss line actually increases more and more above the profit and loss line of the stock position itself so as we see more and more profits come in on the short call we see a larger gap between the profits and losses on the shares themselves compared to the covered call position overall and that illustrates how a short call position actually protects your stock position in the event that the stock price is falling but in terms of managing this covered call position what should we have done in this particular scenario remember that we collected about 325 in premium for selling this call initially and that means the maximum amount of profit that we can make from the short call portion in this covered call position is 325 dollars from that short call and if we look at this graph we can see that at around 23 days to expiration the short call is actually profitable by about 325 and that basically means that the short call was essentially worthless even though it had around 23 days left until expiration so at this point in time with 23 days to expiration and a near 100 profit on that short call portion of the trade it would make a lot of sense to go ahead and buy back that short call therefore closing the short call position of the covered call trade and by doing so we would secure that near 100 profit on the short call position of the trade and we would effectively remove all of the risks associated with holding that short call so basically the closer the short calls price gets to zero the less benefit it serves us but we're still holding that short call which means if the stock price rips higher then we could be faced with a scenario where we actually do lose our shares at the end of the covered call trade when we could have avoided that situation altogether by simply buying back that short call when it was nearly worthless all right let's move on to situation number two which is a neutrally trending stock price with a little bit of a twist at the end so in this situation we are buying 100 shares of stock at around 121 dollars per share and we are shorting the 130 call option for 3.08 cents and this call has 43 days until expiration now as we can see in this particular situation the stock price trades fairly neutrally throughout the trade and we can see that the short call loses value steadily generating steadily growing profits on that portion of the trade so as the short call actually loses value as the passage of time happens and as the stock price does not increase substantially we actually see profits on that portion of the trade because as a short call trader we want that call options price to go to zero which does happen as the stock price remains below the strike price as time passes so the short call is essentially worthless around 15 days to expiration meaning that we've made almost 100 of the profit on the short call portion of the trade at that point in time now again it makes sense to close the short call at this point in time because since we've already made 100 of the profits that we can make on that short call and it still has 15 days until expiration it makes no sense to continue holding that short call because we've already gained all of the benefit that we can make from that short call but if we continue to hold it we still hold all of the risks associated with it which we can actually see by looking at the end of this trading period so if we imagine a scenario where we foolishly did not close that short call when it did approach that 100 percent profit mark we can see that that decision would have come back to bite us because the stock price surged in the final days of this trade so we can see the short calls profit went from almost 100 profit to zero percent profit and only a couple days as the stock price went from 120 per share to 133 dollars per share leaving the short call in the money at expiration so we went from a situation where we had two weeks left until expiration and the short call was basically worthless and we had that full approximate 300 profit on that option but if we did not close that position at that time and we continued to hold the short call unfortunately the stock price ripped higher in the final days before expiration and the option was about three dollars in the money at the time of expiration which means in the end we didn't make any profits or losses on that short call which basically means that the stock position and the covered call position really had similar performance as opposed to the scenario where if we closed that covered call we closed the short call when it had that max profit and then we continued to hold the shares then we actually would have come out way ahead in the end so let's move on to situation number three which is a little bit trickier in this third covered call scenario we are looking at a trade in which we enter the covered call position but we see the stock price steadily increase over the entire duration of the trade specifically we are entering this trade by purchasing 100 shares of stock at around 125 dollars per share and we are shorting the 135 call option for around 80 cents now this call option has 45 days until expiration as illustrated in this graph we can see that the stock price increases very steadily over the entire duration of the trade going from the entry price of 125 dollars per share up to about 145 dollars per share by the end of the trade and on the bottom portion of the graph we can see that the short call loses money for us as the stock price increases and that's because the call option is increasing in value and if we short a call option and it increases in price from the price that we sold it for we are going to see losses on that portion of the trade by the end of the trade the call has lost about one thousand dollars meaning that the price increased about ten dollars from our initial sale price of 80 cents and that results in the covered call underperforming simply holding the 100 shares of stock so if we were to hold the covered call position to expiration we could simply allow the short call to expire in the money and that would mean we would get assigned on that short call and effectively sell our 100 shares of stock at the cost strike price of 135 dollars we would make approximately eleven hundred dollars on the trade at that point but we would end up losing our shares since if we get assigned on the short call then that means we are going to sell 100 shares of stock at the call strike price and since we initially purchased 100 shares of stock by getting a signed on the short call we effectively just sell those shares at the call options strike price of 135 dollars so if we wanted to keep our shares in this particular situation we would need to buy back the short 135 call at some point but if we bought back that 135 call at expiration we would realize a loss of eleven hundred dollars on the portion of that trade and that's not an ideal situation but if we go back and analyze the performance of this position throughout the duration of the trade there is a way that we could have managed this a little bit differently and come out ahead so let's go ahead and look at that if we pay attention to the short call p l and the stock price over the first 20 days or so of the trade we can see that the stock price increases from 125 dollars up to the short call strike price of 135 dollars and it does so very gradually now since the stock price increases slow and steady the short call actually didn't gain much value so if we look at 23 days to expiration the stock price had increased almost 10 dollars from the point of entry but the short call was still around break even meaning the options price was fairly close to the value we initially shorted it for now this can be explained by the options extrinsic value to k offsetting the losses from an increase in the stock price and in terms of the option greeks basically that means the short calls positive theta or time decay was enough to offset the negative delta over the first 20 days or so resulting in little change in the options price so a short call has negative delta meaning it loses value or the short call position will lose money as the stock price increases but it has positive theta meaning that the short call position will make money from the passage of time so basically what i'm saying and what we're seeing here in this chart is that since the stock price increased but the call options price did not increase very much that means that the passage of time was enough to offset the increase in the stock price or the losses that result from the increase in the stock price in this particular situation so if we were in this covered call position and we saw the stock price steadily rising towards our short call position and we didn't have any notable losses on the short call we are in a we are in a position to buy back the short call if we anticipated the trend to continue so the key here would be to observe the upward momentum and see the opportunity to close the short call at no loss so basically if we see that the stock brace is increasing towards our short call strike price but it's doing so very slowly and steadily and we're not really seeing any losses on the short call we could actually go ahead and close the covered call by buying back that short call and if we close it for no loss then no harm at all we close that short call and we can continue to hold the shares now this would be advantageous in this particular situation because if you think that the stock price is going to continue to increase and you're getting a little bit scared about having that short call there which caps the upside on your shares then if the stock price is increasing gradually enough where you're not really seeing any notable losses on the short call you can go ahead and buy back the short call therefore uncapping the upside on your shares and you will not have realized any losses on that short call portion of the trade now this is only possible if the stock price is increasing slowly and steadily because in the next example as we'll see a quick increase in the stock price is going to result in very quick losses on the short call portion of the trade so let's dive into situation number four in example number four we are going to look at a stock price that increases quickly but then actually comes back down so in this trade we're buying 100 shares of stock at around 130 per share and we are shorting the 140 strike call option for and 50 cents now in this particular situation the call option has 46 days to expiration so here in this situation we can see that the stock price trades fairly neutrally in the beginning of the trade but then we can see that it surges from 127 dollars per share to about 143 dollars per share in just a few days time as we'd expect with a quick increase in the stock price the short call position actually loses money in this trade because the stock price gains value very quickly and when that happens that means the call option that we are looking at is actually going to gain value as well so if you see a quick increase in the stock price and it goes above your short call strike price more than likely you're going to have a loss on the short call portion of that trade because that call option is going to gain value very quickly and if it exceeds the price that you initially shorted it for then you are going to have losses on that portion of the trade personally if it were me i probably would not buy back the short call for a loss because if i am entering into a covered call position then i am accepting the fact that i may have to close my share position at the strike price of the call that i have sold as part of this covered call trade and with 25 days left until expiration there's plenty of time left for the stock price to potentially come back down and we could see a scenario where at expiration the stock price is actually below the short call strike price which would allow us to have the maximum profit from the short call position of the trade and we could actually continue holding our shares as it happened in this example the stock price did fall back down and we did see profits come in on that short call now at around 15 days to expiration the short call profit was approaching 250 dollars and this is notable because that's a majority of the maximum 350 dollars that we could make from the short call so since we collected 350 in premium on that short call initially there is a maximum 350 profit that we can generate from the short call position in this particular example so if the profit on that portion of the trade gets to 250 based on what we talked about earlier in this video many times the more profitable that short call position becomes the more logical it is to actually close the short call and buy it back in terms of why we might close that position at that point in time well if we initially saw the stock price surge through our short call strike price and we were considering closing that but then actually the stock price dipped back down below the strike price and we had the opportunity to close this short call for more than 50 percent of the potential profit and we anticipated that maybe this was a leg down setting up for another leg higher then that would present an opportunity to get out of that short call for a profit and just simply hold the shares and reassess doing a covered call in the future but again that's speculation and we do have the benefit of hindsight here but just talking through what could be going through your head at that moment that is one possible outcome if we held this position all the way to expiration and we did not manage it at all we actually would have made the full profit of 350 on the short call position of the trade but the stock price actually ended fairly close to the initial price that we had when we entered this covered call position and therefore we wouldn't really have made or lost any money on the shares but since we made 350 on the short call position we would have made about 350 overall in this covered call if we held it all the way through expiration so now i want to move on to talking about early assignment risk because this is a very common question i get from people who are trading covered calls if you're trading a covered call and the stock price gets above your short call strike price sometimes people will start to panic and they'll start to worry about early assignment the first thing i want to say is that if you are assigned on a covered call position meaning that you enter into a covered call the stock price gets above your short call strike price and then you get assigned on that short call you will realize the maximum profit of your covered call position so getting assigned is not a bad thing the only reason it would be a bad thing is if you actually wanted to continue holding your shares and you were planning on buying back that short call for a loss or whatever at a certain point in time and in that case then it might be a bad situation but overall just know that if you do get assigned on the short call and you're trading a covered call you will realize the maximum potential profit from that position so it's not a bad thing in terms of p l in that last example i talked about holding that covered call position when the stock price did get above the short call strike price now i know you might be wondering well how do you know you could have been able to hold that position because what if you were assigned on that short call well to gauge early assignment risk what you have to do is you have to look at the extrinsic value that exists in your in the money short option now i did an entire video talking about why options are rarely exercised and that video is called why options are rarely exercised and you can watch that video by clicking the card somewhere up here i don't know where it is or you can click on the video link in the description below to check out that video i explain in great detail why options are rarely exercised and if you're trying to understand what i'm talking about here then i would definitely check out that video after watching this one but to keep things simple here all you have to look at when assessing early assignment risk is the extrinsic value that exists in the short in the money option in your portfolio the closer the extrinsic value gets to zero the higher the likelihood that you will face early assignment on that short in the money option if we go back and analyze the extrinsic value that existed in these short calls as part of these covered call examples then we can get an idea as to when these covered calls or short calls were actually getting to the point of being at risk of early assignment i wouldn't really consider an option to be at high risk of early assignment unless it is in the money with less than 25 or 50 cents of extrinsic value now that's definitely an arbitrary level so don't take my word for it but generally speaking the closer and in the money options extrinsic value is to zero the higher the likelihood of early assignment so i just use that 25 to 50 cent level as kind of a guideline as to when that extrinsic value is getting low enough to where i start worrying about early assignment so let's go back to that example where the stock price searched quickly above the short call strike price and then traded back down so as we can see here even though the short 140 call was in the money when the stock price surged the 140 call had over five dollars of extrinsic value during the time when it was in the money now based on the high amount of extrinsic value in that call option when it was in the money i would say there's virtually zero percent chance that that option would have been exercised by the owner and therefore as a covered call trader there is virtually zero percent chance that we would have been assigned on that short call position because if a call option owner exercises the option when it has five dollars of extrinsic value they are literally burning 500 of value in that call option and if they wanted to buy 100 shares of stock instead of exercising the call option they could have simply sold the call option and purchased 100 shares of stock which i call the synthetic exercise so they would not have to unnecessarily burn that 500 of extrinsic value they could have simply just sold the call option avoided that unnecessary loss and purchased 100 shares of stock if they wanted to do that but let's shift focus to the other example that we looked at earlier which is where the stock price was increasing steadily and got very notably above the short call strike price by the time of expiration so this time around we can see that the short 135 call becomes in the money around 19 days to expiration when the stock brace breaches that 135 dollar price level at this time the 135 call has over 1.50 of extrinsic value and is therefore unlikely to face early assignment in my opinion one dollar and fifty cents of extrinsic value is a lot of extrinsic value and at that level i really would not consider that option to be at risk of early assignment however an options extrinsic value will get closer to zero based on two things the passage of time so the closer the option gets to expiration the less extrinsic value it will have but also the further in the money an option gets the less extrinsic value it will have so if we combine these two factors we can see that we can get a very quick decrease in the options extrinsic value as illustrated in this graph here if we estimate that an option is at high risk of early assignment when the option's extrinsic value falls below that threshold of 25 cents then we would say that this short 135 call was at risk of early assignment when it had about 10 days left until expiration and at that point in time the stock price was around 143 and that means that the short 135 call was eight dollars in the money with 10 days left until expiration the bottom line here is that if you're trading a covered call position and the stock price does get above your short call strike price there's no need to panic because if it's early in the trade say you have more than two weeks or 14 days left until that option expires there is a good chance that that in the money call option is going to have a lot of extrinsic value which means it's very unlikely that you will be assigned before expiration on that short call but as the stock price gets higher and higher above the short call strike price and as the option gets closer to expiration the extrinsic value of that call option is going to get closer and closer to zero and that is a scenario where you are going to have a higher likelihood of being assigned early on that short call just want to take a quick moment to talk about my preferred brokerage that i love which is tastyworks i trade with tastyworks because they have incredible pricing and fees they have a one dollar commission per option contract when you open the trade but all trades are free to close with the exception of the small regulatory and exchange fees but the special thing about tastyworks is that they do have a 10 maximum commission per option leg so for example if you were to buy 100 call options instead of paying one dollar per contract times 100 contracts which would be a commission of 100 you would only pay 10 for purchasing those 100 contracts and that is a huge saving to you so by trading with tastyworks you can save a ton of money in options trading fees they also have free stock trading and they have a very easy to use and intuitive platform which i use every single day for my options trading so be sure to check out tastyworks in the link down below they're actually running a special promotion right now through the end of september in which you can earn up to two hundred dollars in free crypto for opening and funding an account with more than two thousand dollars and you will also be eligible for the exclusive project option options trading course that is on our website and is completely exclusive and cannot be found on this youtube channel so be sure to check out those links down in the description below to learn more we moved very quickly in this video and did a lot of situational analysis related to managing covered calls so be sure to check out my intro video to covered calls if you are a beginner and you struggle with some of the concepts in this video be sure to watch that video here as it will definitely help you make more sense of the covered call strategy

Channel: projectfinance

Views: 26,325

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Keywords: projectfinance, projectoption, chris butler, stock market, finance, covered calls, covered call options strategy, covered call management, managing covered calls, how to manage covered calls, options trading, options trading for beginners, covered call option strategy, writing covered calls, selling covered calls, trading covered calls

Id: dMIVyPcENA0

Length: 25min 33sec (1533 seconds)

Published: Fri Aug 06 2021