The Right Way to Trade Covered Calls For Income

writing covered calls is one of the most popular option strategies for retail investors to employ the problem is that most people use covered calls the wrong way and then get themselves into unnecessary problematic situations because they haven't fully understood the purpose and the right way of trading covered calls i'm seth freubert the head trader of smb capitals options trading desk here in manhattan and traders from all over the world reach out to us asking for advice on covered call strategies all the time in today's video we're going to cover the right way to trade covered calls so that you avoid all the pitfalls and instead reap all the benefits of the strategy so if that sounds like it's something you'd be curious about then stick around i think this is going to be very useful for you [Music] hi i'm seth royberg and i'm the head trader of smb capitals options trading desk smb capital is a proprietary trading firm located in midtown manhattan and we provide capital for options and equity traders from all over the world trading both remotely and in our offices here in new york city now i'd like to suggest that you click on our subscribe button right now so that you don't miss any of our free trading videos that we produce for traders and investors all over the world they're really valuable okay so many of you have probably heard of covered calls which is a technique that many traders and investors use to create monthly income from stocks that they own and while you certainly can create monthly income from trading covered calls like anything else in life there's a right way to do something and a wrong way and unfortunately most traders picked the wrong way and end up getting burned which is entirely unnecessary if you just follow a few key principles to effectively utilize this strategy now just to review what a covered call actually is and it's going to be quick for those of you who already understand the concept in order to understand how covered calls work we'll need to understand what a call option is exactly and so a call option on a stock entitles the buyer of that option to buy 100 shares of a stock at a certain price called the strike price of that call option at any time after the call buyer buys that call option the call buyer pays what's called a premium to the seller of the option because the seller of the option is taking the risk that the stock will go way above the strike price of that call option in which case the buyer can exercise his option and force the call seller to sell his shares at the calls options strike price which is lower than they're worth okay so that's what a call option is now a covered call for monthly income starts out with your owning 100 shares of a stock and then every month selling a call option on those shares that you own usually at a strike price higher than the stock is trading at now before we get into exactly how traders typically earn monthly income trading covered calls i wanted to let you know that if you want to learn three more option strategies that our pro traders use including the unique options trick that allows you to make money while you wait to buy stocks or etfs at the price you want or the options income strategy that allows you to make consistent money whether the market goes up down or sideways and how to make money on a stock or index trade even if you're out right wrong on the direction then click the link that should be appearing now at the top right corner of your screen that's going to open up a free workshop registration page in a new window so don't worry you won't lose this video or you can register directly for free at optionsclass.com believe me you don't want to miss this so pause this video sign up now and then resume watching getting back to covered calls how exactly do you make money trading covered calls and the answer lies in the two possible outcomes of a covered call the first outcome is the one that creates monthly income for a trader and that's when the stock on which you've written the covered call closes below the strike price of the call in that case then the call expires worthless and the premium you collected for being the seller of that call just becomes income for you the option dies and you have no further obligation you get to keep the premium you collected originally so for that month the trader would receive simply the premium he sold but in another month if the stock closes above the strike price of the call option on the day it expires the call buyer would naturally exercise his right to buy those shares at the call strike price which is below where the stock is trading and thereby making an immediate profit so in that month the trader shares are sold although he did make the income from selling the call in the first place he gets to keep that cash that he was paid by the call buyer but the issue is that in order to continue to get income the trader would be required to buy the shares back again at a higher price this time in order to resume the covered call program for income so let's show you an example to pull all this together for you so let's head back to march of this year and as you can see walmart after initially bouncing off of its pandemic lows near 100 rallied all the way up to 150 and then sold off to 130 by early march of 2020. so if a trader were to have bought 1 000 shares of walmart for the purposes of executing a covered call strategy to bring in about two thousand dollars a month he'd most likely start out by going out about a month to april first and selling 10 of those 133 walmart calls which expire on april 1st at a price of two dollars in one cent now let's drill down to understand what happened here in the first portion of this campaign to bring in the two two thousand dollars per month with covered cost so that we can follow along with how the campaign's going and as you can see we spent one hundred thirty thousand one hundred ten dollars on the shares initially at a hundred thirty dollars and eleven cents a piece but you'll also see that we sold ten of those april one 133 strike price calls for 201 a piece but remember each option represents 100 shares of stock so you multiply that by 100 and we sold 10 of them so the cash flowing into our account for selling those 10 calls is and ten dollars which remember was this trader's goal of making two thousand dollars a month from his walmart shares and therefore net of that cash flow from the calls that were sold the cost of the campaign is one hundred twenty thousand one hundred dollars okay so now let's move to the day that those options expire on april 1st and you'll see that walmart had actually rallied by then to 135 and so the stock closed above the 133 strike of the 10 calls we sold and so we are required to sell our shares at 133 to the one who bought those calls from us and so now if we want to continue this campaign we're going to have to buy those shares again but this time and this is a crucial point this time we have to pay over 135 dollars a share because walmart had rallied to that level causing our shares to be called away at 133 and to make another 2 000 or so dollars we go out another 30 days to april 30th and sell 10 of those 137 calls this time for 2.35 cents now moving to april 30th we see that walmart had rallied some more up over 139 and so it's going to be a repeat of what happened 30 days earlier and those shares are going to be called away again 437 because the call buyer will want to cash in on his right to buy them cheaper than they're trading in the open market and so here is where we are after that happens as and as you can see if you take the cash that we got from selling the first set of shares at 133 in early april april and you subtract out the cash you paid to get into that first covered call transaction and then subtract out what it costs to buy those shares again at 135 and 62 cents and add back the 2250 you got from selling the second set of calls at the 137 strike you'll see that you now have a profit on this campaign so far of 85 30. now keep in mind that to restart the campaign we basically are forced to buy the shares of walmart yet again but at this time the price is even higher at 139.91 as you can see and so that starts a new cycle of cash out outflows starting with the purchase of those new walmart shares at the higher price now over the next few months walmart actually didn't move very much and so the calls expired worthless for the next two monthly cycles which ended at the end of may and june where we pocketed two thousand sixty dollars and eighteen hundred and fifty dollars respectively so we add that in as a positive cash flow as you can see from the calculation and in late june we sold the july 23rd 139 calls for 1840 but after that walmart rallied again but this time to 142.43 and so again we were forced to sell our shares lower than that at the 139 strike price and so we received in 139 000 for those shares and so on july 23rd we again needed to rebuy the shares this time at a total cost of 142 430 dollars and at the same time selling the 144 calls for 23.20 now on august 20th let's just say we decided to end the campaign well by that point walmart had again rally this time up to 150 154 near its all-time high and so once again we're forced to sell the shares way below market at 144 and so we received 144 000 for those and so when you add back the profit we had made on the campaign from april 30th the total profit for this campaign focused on producing cash flow of about two thousand dollars per month netted a final profit of seventeen thousand two hundred sixty dollars now that sounds like a lot of money but what if i told you that there actually was a major flaw in that whole concept some of you may have spotted it and others may not have but i think once we go through this next example you'll clearly see what that flaw is so let's go right back to the beginning on march 2nd and take another look at this price chart for a minute and so if you approach this differently and instead make the supposition that walmart was likely to bounce and retest its highs from earlier in the year and we saw this drop to 130 as a buying opportunity then we could have handled this covered call program very differently and instead of creating a goal of making two thousand dollars a month off of our walmart shares and having to rebuy them every time the shares get called away instead of that we can say to ourselves let's forget about exactly how much income we're going to try to generate each month and instead let's establish a game plan that if the stock gets back to its all-time highs we'll take our profits and move on so instead of selling any call that gets us two thousand dollars a month no matter how close it is to walmart's price instead we'll just keep selling calls at that 150 strike price our profit target and if our retest theory holds up we allow the stock to rally all the way up to 150 without having the shares called away periodically because in order to sell calls that make us two thousand dollars each month we're forced to sell calls that are so close to the current walmart price that our shares keep getting called away and we have to keep rebuying them at higher prices and starting again so let's see how that would play out if we handled things differently focusing on our price target for more mark and as you can see we again of course start out the same way buying a thousand shares of walmart on march 2nd for a little over 130 thousand dollars but this time we sell the 150 calls and you'll note that we only receive 240 for those because those calls are so far from the walmart price of 130 that they represent very little risk to the call sellers of them being exercised so the price is lower than the two thousand dollars we've received each time we sold calls in the previous campaign and so we've listed for you the premiums we've received each month through the august calls again but this time we are strictly only selling the calls at our price target of 150 and as you can see those prices range from as little as a hundred dollars and as much as eight hundred dollars but in all cases are lower than the two thousand dollars a month or so that we were receiving the previous style of covered call campaign where we are simply focusing on receiving that income each month and then you'll notice we don't sell the shares until august when walmart reaches 150 that's the first time we actually sell them at the very end of the campaign and that's because walmart has exceeded our price target of 150. so now when you net it all down you end up with over 22 000 from this style of covered call campaign where you focus on the price target of the stock and then collect income until you hit that price target as opposed to focusing on some fixed amount of income and then forcing yourself in and out of the shares and worse forcing yourself to re-buy them at higher prices each time you re-establish the campaign causing you to basically skip over some of the upward price movement a practice which turns out to be so expensive that it blows away the supposed advantage of collecting a steady two thousand dollars each month so what i'd like you to take away from today's video is the fact that a covered call program can be terrific if you handle it correctly but it can also be cumbersome and much less profitable if you don't setting a price target on a stock and then selling calls at that price target is a perfectly sound way of getting extra income from an investment because selling the calls actually enforces a discipline of taking profits on stocks when you think they're fully valued and until then you are letting the stock breathe and not forcing yourself in and out of the trade missing price movement each time and costing yourself a bundle in the process you will still make income each month but less the bigger payoff is in the end if and when the stock hits its price target at which point you've maximized your return on the trade which is the goal of every trade that professional traders make now just to remind you if you're serious about your trading you need to check out the free intensive options class that we're currently running where you'll learn three real world option strategies that our professional options traders use all the time just click the link that should be appearing out the top right corner of your screen or you can head on over to optionsclass.com to register for this free workshop directly it really is a rare opportunity for retail traders and investors to learn directly from wall street traders but that's exactly what you'll be getting through this free online workshop so click the link to sign up now before you miss it please don't forget to hit our subscribe button right now so that you don't miss any of our free training videos to help you to improve your game as an options trader

Channel: SMB Capital

Views: 52,824

Keywords: stock market, day trading, smb capital, trading, investing, markets, wall street, stock trading, options trading, options income, economics, finance

Id: Vm0qcsR5-E4

Length: 15min 19sec (919 seconds)

Published: Thu Dec 09 2021