How to Trade a Covered Call

hey everyone welcome back to the show my name is Mike this is my whiteboard and today we're going to be looking at the covered call strategy but we're actually going to look at adjustments we can make to that regardless of what happens with our strategy but we're going to look at when the stock price goes up stays the same or goes down so the main key here is that we're going to be looking at the mathematics behind it we're going to calculate our breakevens I realize profit or loss and we're going to really dive into what we're looking for when we're rolling a trade or when we're calculating these things so it's going to be really exciting segment I think we've got a few more of these I like to do these adjustment strategies and adjustment segments because we do get a lot of questions through the support channels about what people can do with certain trades when it comes to strategy and how it all works so I'm going to walk through covered calls today I've got short puts tomorrow I can do a ton of other strategies if you'd like so shoot me an email or a tweet if you really like it but we'll get right into it today with covered calls so let's go to the next slide and we'll just visualize what a covered call is and we'll look at some basic calculations here so we've got our opening trade and a covered call if we just remember back is just buying 100 shares of stock at the current stock price and then selling and out of the money call against that so we're looking here at the 80 strike call to sell against our 100 shares of stock at the 75 price point so our 80 call has 45 days till expiration and that's going to give us a nice premium here of $1.00 25 so when we walk through the different calculations here let's first talk about Max profit so we've got our stock price at 75 again for this call to be covered this short call to be covered we need to buy 100 shares of stock if we buy anything less than 100 shares our short call would not be fully covered by our shares of stock because when we remember back to what a contract is dealing with every option contract that's our standard contract is looking at the theoretical equivalent of 100 shares so if I'm selling a call at the 80 strike at expiration if this strike is in the money are in other words if the stock price is above anywhere above 80 this short call is going to turn into 100 short shares so since I'm long 100 shares at 75 this is considered a covered call so let's look at the max profit here of 625 so let's take a look at 625 and just look at these values here and we can clearly see where I'm getting that value from so the max profit is realized if the stock price is at 80 or anywhere above 80 at expiration so we just take the difference between where I purchased the stock at 75 or 75 hundred dollars for 100 shares we calculate the difference of our strike price in our stock price which is five points or five hundred dollars and then we take into consideration the credit received of a dollar twenty-five so at expiration if the stock price is above 80 I would have long 100 shares at 75 short 100 shares at 80 which would wipe out my position but since I collected a dollar 25 in addition to that my max profit is going to be capped at 625 regardless of where the stock price is above the level here so with that said my max loss is going to be 73 75 in the way I calculated this is just by taking my 100 shares at 75 and subtracting the cash premium that I'm receiving for selling this call at the 80 strike so I'm taking 7,500 subtracting a dollar 25 or 125 dollars and that gives me my max loss if the stock price ends up going to zero in this situation because I've got this basic strategy here my max loss is also going to be my breakeven price and that's going to be the case when you're just opening a trade so we're putting on a trade right from the get-go our max loss in this situation is going to be our breakeven point and that's only going to be realized if the stock price ends up going to zero or going out of business so let's take a look at some things we can do when the stock price changes so let's go to the next slide here and we'll break down what happens when the stock price increases as you can see by this symbol here so we've got our original trade that had 45 days to expiration now let's say that we're on expiration day it's the Friday of expiration I've only got a few hours left to trade this option in this position and I've got 0 days here and I'm lucky enough to be able to buy back my short call at the 80 strike in that same expiration for 5 cents so as you can see the stock price has moved from 75 to 79 I still own my shares at the 75 mark but I'm able to close my position out and effectively capture the realized profit on this short call of a dollar 20 as you can see I sold it for a dollar 25 but since I have to buy back for 5 cents I'm going to be looking at a net credit received of a dollar 20 there and that's going to give me a realized profit of five hundred and twenty dollars so we've got a hundred and twenty dollars from the short call that I originally sold but I bought it back so that's considered the closed position and my stock price went from 75 to 79 so you take the $400 I would get from the stock price increasing from 75 to 79 add that to the net dollar 20 credit from my original position and that gives me the realized profit of five hundred and twenty dollars however I'm going to look at keeping the dream alive here and I still have the bullish assumption so what I'm going to do is look to sell a new call at an 84 strike with a new expiration of 40 days until expiration so knowing this my new profit potential on my current trade is going to be six hundred and twenty dollars and I'm calculating that by just taking the current stock price which is seventy nine looking at my short strike of 84 which is a five-point difference and looking at the credit of a dollar twenty you add those two values together and you've got your new potential profit of six hundred and twenty dollars my new breakeven is actually going to be 72 sixty so we're moving all the way down into the 72 level and that's because of the fact that I took my original 75 stock price that I purchased it at I've got my dollar twenty net credit that I received from my previous position and I'm adding another dollar 20 credit here with my new position so I take the dollar 20 here subtract that from 75 and subtract another dollar 20 from my new position which gives me a new breakeven of 70 to 60 so 2 dollars and 40 cents from between these two subtract that from 75 and you've got 70 to 60 so this is a great way to continually reduce cost basis especially when we're in winning positions like this and we got lucky with this one because we were right on the brink of the 80 strike but the stock was at 79 and I was able to buy back that that call there right on the expiration day so we got lucky with this situation let's go to the next slide and talk about a situation that would go against us so let's say the stock price actually goes down so now this is where things get a little bit more difficult to calculate because we're looking at some interesting numbers here we're going to go through the same process so let's say I've got that same position but in a different simulation the stock price went down to 70 so we originally purchased the shares at 75 stock prices now at 70 and I've got 10 days to go until expiration well the stock price is 10 points away from my long call or my short call that I sold so I'm able to buy that back for one penny which is the lowest I can possibly buy it back at so knowing this I want to hedge my position even further so I know that I purchased the shares at 75 so if I move my new call down to 77 as opposed to 80 I can still reduce my cost basis a little bit further give myself some profit potential and it's going to reduce my max loss overall so I look at moving the strike down to 77 which is still above my 75 purchase price of the shares so I'm okay there and I've got 30 days to go for this one so I'm going to look at these numbers here and they seem a little complex but we can easily calculate them so let's take a look here so we know that my original breakeven point point was 73 75 so we just had 75 - 125 73 75 if I buy back the OP that I sold for one penny that would mean my breakeven would be 73 76 however I'm selling this new call for 60 cents which gives me my new breakeven of 70 316 so I've got 73 76 subtract that short call that I'm now selling against my shares gives me that breakeven of 70 316 which means that if my breakeven is 70 316 my current loss is 316 dollars because the stock price is trading at 70 but if the stock price ends up coming all the way back up above 77 which is where my profits would be capped at this point my new profit potential in this trade would be 384 dollars because I would be able to wipe out this current loss of 316 and it would give me that new profit potential of 384 which is what I would receive above my breakeven point if the stock price did go up so now let's look at the next slide and we'll look at a different scenario if the stock price doesn't move at all and this one is the easiest one to calculate in my opinion so let's say the stock price stays the same exactly the same in that for that matter so we've got three days to go until expiration and I'm able to buy back this call for 10 cents and I'm looking to just continue to reduce my cost basis so I'll sell the same exact strike that I'm comfortable with for 43 days until expiration and as you can see maybe implied volatility has increased a little bit because I'm selling this call for a dollar 40 as opposed to a dollar 25 now so let's walk through how we can calculate our realize profit and break-even point so bought the shares at 75 sold the call for a dollar 25 so that gave me the break-even of 73 75 originally however I bought back the call for 10 cents so now I'm at 73 85 however I'm going to sell a new call for a dollar forty so 7385 minus a dollar forty is seventy two forty five and that means that my realized profit is a dollar fifteen and that's because if I've got all these variables here and all these numbers here you can see how they all relate together so essentially the stock price didn't change so I did not receive any profit or loss on the stock position it's exactly the where it was when I originally put the trade on but I was able to sell that call and buy it back for 10 cents so I've got a net profit of $1 15 here which means that my new potential is going to be 640 dollars and that's easily calculated just by looking at the stock price here so the stock price did not change at all still at 75 as it was when I open the trade but now I've got the ability to sell another call for a dollar 40 so my new profit potential on this brand new trade is simply the difference between the stock price and strike price so five points plus the dollar forty and credit which gives me the $500 plus a dollar 40 of 640 dollars so let's wrap all this together with some takeaways here so the number one takeaway is that selling premium helps us weather the storm as you can see regardless of whether the stock price goes up which is good for us in a covered call position stays the same which is also good or goes down really we're able to reduce our cost basis in all three scenarios which gives us a higher probability of being successful in the long run secondly when it comes to adjustments it's all about cost basis reduction so we never really know whether a stock is going to go up stay the same or go down we can have our assumptions but if we reduce our cost basis that's really what gives us success in the long run when it comes to just generating a number of occurrences and continually reducing our cost basis if I continue to do that and I was able to hold those shares for a very long time I could own those shares for $0 because I would have reduced my cost basis all the way to zero and lastly when maneuvering keep in mind probability of profit and break-even price so we're always going to want to decrease our breakeven point or make the break-even point better for us for whatever strategy that is but we're also going to want to keep in mind the probability of profit on our new trade and keeping all these things together is really what's going to make us successful traders in the long run so thanks for tuning in hopefully you enjoyed these adjustments for the cover call we've got short put adjustments tomorrow so stay tuned if you've got any questions or feedback at all shoot me an email at support at doe comm support a tasty calm or tweet me at doe trader Mike shadow traders are up next so stay tuned hey everyone thanks for watching our video if you liked this video give it a thumbs up or share it with a friend click below to watch more videos subscribe to our channel or go to our 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Keywords: covered call, covered calls, covered calls explained, covered call option strategy, covered calls for income, covered calls for beginners, selling covered calls, covered calls strategy, how to sell covered calls, covered call option, covered call options, covered calls options trading, selling covered calls for income, how to trade covered calls, trading covered calls, selling covered call options, covered call options strategy, options trading for beginners, tastytrade

Id: i8eeZBmXdto

Length: 13min 54sec (834 seconds)

Published: Wed Apr 13 2016