how to write covered calls

Write Covered Calls

How to Write Covered Calls – An Aggressive Strategy

When we write covered calls one way of doing it is to sell out-of-the-money (OTM) call options over-purchased stocks or futures. The normal manner in which this is done is to own a specific number of shares equivalent to the number of option contracts you will sell. For example, since one option contract in the USA cover 100 shares, you might purchase 1,000 shares and sell 10 call option contracts at exercise prices above the share price on the date of purchase.

The premium you receive when you write covered calls OTM is designed to offset any capital losses should the share price fall after purchase. In such cases, you can buy them back cheaply, then sell more calls at a lower exercise price, bringing in more premium. But you’ll also have less capital gain on the shares should the price recover.

To illustrate, let’s take a look at Cisco Systems shares (CSCO). As at the date of writing, Cisco shares closed at $17.60. We look at a chart and notice an “inverted head and shoulder” pattern, which signals a possible impending price reversal.

So we buy 1,000 shares at $17.60 and sell 10 call option contracts at $19 exercise price and 39 days to expiration. Leaving out future adjustments, our risk graph would look something like this:

Our maximum profit at expiration is $1,630

But You Can Also Write Covered Calls This Way

Now let’s consider a more aggressive way to write covered calls, but this time with much more profit potential without sacrificing risk.

Here’s what we do:

1. Purchase 1,000 CSCO shares at $17.60
2. Purchase 10 x $18 Call Option contracts with 39 days to expiration, for $0.54 per contract
2. Sell 20 $19 Call Option contracts with same expiration period, for $0.23 each = $0.46 total.

You’ll notice that the premium received from selling twice the amount of calls than we bought, gives us an almost zero cost for the options positions. Ideally, placing this part of the trade for even money would be a better alternative, but this should do to illustrate the point for our purpose here. Look out for higher implied volatility in the OTM options if possible, for even money trades.

Now let’s take a look at the revised risk graph.

When we write covered calls using this more aggressive strategy, our maximum profit increases from $1,630 to $2,320. The extra 10 sold contracts are “covered” by the 10 bought contracts at a lower strike price, so there are no extra margin requirements.

Our more aggressive covered call strategy includes slightly more risk since we don’t have any premium to offset a fall in the share price. But then again, should the price fall instead of the anticipated rise, we now have twice as many already $19 “sold” options that we can now buy back for next to nothing and then sell more call options for the lower $18 strike price, thus making a profit.

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Covered Call Writing

Covered Call Writing is regarded as one of the safest option trading strategies. The way it is normally presented is, that you purchase the underlying shares and then sell call options on them. You can sell them out-of-the-money, at-the-money, or even in-the-money, each with different outcomes, depending on current market conditions and expectations.

Purchasing the underlying shares requires a sizeable amount of capital. If the current stock price is say, $40 then it would cost you $4,000 to purchase 100 shares in the USA so that you could write just one call option contract over it. If you wanted to write 10 contracts, the underlying shares would cost you $40,000. Not everyone has that much to risk on just one trade.

But what if there was a much cheaper way to achieve exactly the same effect as a covered call, but for a fraction of the cost. Would a covered call writing strategy like this interest you?

Covered Call Writing – a Cheaper Way to Do It

Instead of purchasing the shares themselves, you buy deep-in-the-money call options with at least one year till the options expiration date. These are called “leap options“. By deep-in-the-money we mean the strike price should be more than 10 percent of the share price in-the-money. So in the case of our present example, if the underlying share price is trading at $40 then we would want to buy call options at least $4 in-the-money, i.e. with a strike price of $36 or less.

Covered Call Writing worked example

We have noticed a stock fall to around $40 recently accompanied by heavy volume and expect that in the near term, it will trade in a range. We could buy multiples of 100 shares at $40 or instead, we could buy $32 call options with one year to expiry. Because they are deep ITM the delta will be very high and most of the value of these options will be intrinsic value with little time value. $32 call options are $8 in-the-money and they cost us $9.40 instead of the $40 we would pay for the shares. This means we can either buy more of them or risk less capital.

To buy 10 long call option contracts at this price will cost us $9,400 instead of $40,000.

At the same time, we also sell 10 at-the-money call options with a strike price of $40 and only one month to expiry. We receive $130 for each contract we sell, a total of $1300 income.

Possible covered call writing scenarios at the expiration date of the near month options:

1. The share price is below $40.

In this case, the sold $40 call options will expire worthless and we keep the $1300. We still hold our $32 call options and we now sell more ATM call options for the next month out.

2. The share price is slightly above $40.

We then buy back the sold calls and immediately sell further call options at a higher strike price for the next month out, making a profit in the process, thanks to time decay.

3. The share price has made a strong move upward to around $50

The sold $40 call options will now be deep-in-the-money and we will be exposed by $10 per share, meaning that we will be forced to sell the shares at $40 when the market price is $50. But at the same time, we hold $32 call options which are now $18 in-the-money.

So we close out both positions. We make a $10 profit on the $32 call options and lose $10 on the sold $40 options so one offsets the other. But we also get to keep the $1,300 from our original sale of the $40 call options.

Overall, in one month our covered call writing strategy has made a profit of $1,300 on an investment of $9,400 which is a 13.82 percent return on risk. Compare this to a strategy that included purchasing 1,000 underlying shares and we’d be looking at a return of $1,300 on a risk of $40,000 which is only 3.25 percent.

We then decide whether to buy more deep ITM call options based on the now $50 share price and sell near-month ATM options again or move on to another stock. Our decision will be based on whether we think the future price direction of this share is to remain steady or fall sharply again.

The abovementioned covered call writing strategy is a great reduced-risk alternative to the traditional covered call. Your sold options are ‘covered’ by the deep ITM options instead of the underlying shares themselves.

In fact, this strategy actually has another name – the Calendar Spread.

Covered Call Writing Strategy

covered call writing

Writing Covered Calls

Writing Covered Calls – Renting Out Shares for Profit

So many people own popular stocks but fail to realize the potential earning capacity, beyond dividends, of the stocks they already own. Writing covered calls is a way to make additional income from some shares. If you combine this with the leverage of margin lending, you can see very impressive returns.

What is a “Covered Call”?

A “Covered Call” is a call option that you write (i.e. sell) to the sharmarket, on shares you already own. It is a promise to the market, that you will sell your shares for a given price by an agreed date, but only if someone who has purchase your promise, chooses to exercise it.

The call option is called “covered” because the promise is secured by shares you own. The alternative to this, is to sell “naked” which happens when you make this promise over shares you don’t own and would therefore have to buy in order to fulfil your promise. Writing covered calls is a much preferred and safer option.

What is “Margin Lending”?

Margin lending is a type of loan easily obtained from lenders who are prepared to finance the purchase of additional shares, using your existing shares as collateral. There are varying margin lending rates applicable to shares according to their perceived risk. The popular “blue-chip” shares usually have a lending rate up to 70 percent.

Writing Covered Calls – How We Use Them Together

Let’s take an imaginary example. You have $20,000 to invest and you want to buy XYZ shares, currently trading at $15 per share. The margin lender will loan you another 70 percent, but you choose to only use 60 percent, so you have a buffer in case the share price drops. This means your $20,000 becomes 40 percent (100 minus 60) of the total shares purchased. Your $20k can now buy $50k XYZ shares, which at $15 per share equals 3,334 shares.

If the stock price moves up one dollar, your gain on
3,334 shares will be $3,334. If you had only purchased $20k of these shares, your gain would’ve only been $1,334. Your margin loan has made you an extra $2,000 less interest on the loan.

Now, let’s combine margin lending with writing covered calls.

You have used margin lending to purchase an extra 2,000 shares and now you write $17.50 call options with an expiry date one month away, on these 3,300 shares. You receive a premium of say, 50c per share, which is a further income of $1,650.

If the share price spikes up to $18 before the options expire, your gain is limited to $2.50 per share, but you have added another 50 cents from the sold call options, so your total gain is now $3 per share, or $9,900 on a $20,000 outlay. Not bad!

If the stock price only moves up one dollar, you’ve made an extra 50 cents from your covered calls, plus your shares have gained one dollar each in value.

If the stock price drops to $13 by option expiry date, your sold call options will expire worthless, which means you won’t be exercised. Your 50 cents per share will offset the loss on your share price and you now turn around and write another covered call contract at $15 strike price, for next month’s expiry date, bringing in further income, again offsetting the loss in share price until the stock price rises again.

This is why writing covered calls is like renting out your stocks. Landlords borrow money and rent out their real estate. Share owners rent out shares. If you stack the odds in your favour and generally pick shares whose price will rise, this is always the best scenario and will provide you a comfortable return on your investment.

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