How to Write Covered Calls: 3 Simple Examples

Overview

In this post, you will learn about covered calls, how to sell them, and how to analyze the risk associated with them. It then goes on to demonstrate how to do it correctly in three different market situations.

What Are Covered Calls?

The covered call technique is easy to understand and execute. Selling a call option commits you to delivering your shares at the strike price for a set time period. A “covered call” is a low-risk technique that generates income and boosts dividends. You can generate monthly cash income by selling call options on stocks that you already own. Selling covered calls is a neutral to bullish strategy. You predict the stock price will remain stable or rise.

The Advantages of Selling Covered Calls

This investment approach performs best when the market is rising. A rising market might assist in increasing the premium on a stock. Another advantage of covered call investing is that the method can help minimize costs in a falling market as well. Covered calls help you reduce losses by offsetting the drop in stock value with premium income. Investing in covered calls can dramatically boost your portfolio’s yield if you plan to own the stock for a long time.

Covered Calls Writing Tips

Write call options on your stocks once a month or once a week. Most of the big premiums are made in shorter amounts of time than months. There are a few general rules to keep in mind: Writing calls with a strike price close to the stock price makes the best profits. In this case, if the strike price of the call is higher or lower than the stock price, the premium returns are less. Also, the returns are better for shorter expiration dates.

See also  What About Selling Covered Calls in a Down Market?

Covered calls should be placed on equities that you are comfortable holding for a long time. They should be long-term winners that can be held even if the market declines. Covered call investing is a bullish technique. Companies with growing sales and profitability are the ideal prospects for covered calls.

When looking at stock prices, there are three main factors that should be taken into account:

  • Anticipate stock prices to remain constant.
  • Expect stock prices to rise.
  • Expect stock prices to decline.

Stock Prices Remain Constant

StockOption
Purchase Date 1/28/2022Sell Date 1/28/2022
APPLEExpiration 2/18/2022
(19 days till expiration)
Strike Price $170
Purchase Price $170.30Sell Price $5.28

For each contract sold, you’d earn $528 ($5.28 X 100).
Here’s how to calculate the return yield:

Stock price is less than $170 on 2/18/2022.

Calculate the rate of return using the following formula:

[Call Option Premium Earned + Stock Price Appreciation] ÷ [Price Paid for the Stock – Call Option Premium Received]

= [$528 + $0] ÷ [$17030 – $528]

= 3.2%

Selling an AAPL Feb 2022 covered calls at the money

Assuming the stock price remains constant throughout the contract, you keep your stock, and it is not sold to the option buyer. You keep the premium and write a new call for the following month.

Stock Prices Rise

StockOption
Purchase Date 1/28/2022Sell Date 1/28/2022
APPLEExpiration 2/18/2022
(19 days till expiration)
Strike Price $175
Purchase Price $170.30Sell Price $2.92

For each contract sold, you’d earn $292 ($2.92 X 100).

Stock Appreciation: $17500 (Strike Price Agreed to Sell) – $17030 (Purchase Price) = $470

Here’s how to calculate the return yield:

See also  How To Profit from Covered Calls: Citizens Financial Group

Stock price is higher than $175 on 2/18/2022.

Calculate the rate of return using the following formula:

[Call Option Premium Earned + Stock Price Appreciation] ÷ [Price Paid for the Stock – Call Option Premium Received].

= [$292 + $470] ÷ [$17030 – $292].

= 4.55%.

Selling an AAPL Feb 2022 covered calls out of the money

In a rising market, the stock is more likely to be called. If the share price climbs over the call strike price, it may be called, or sold to a call buyer. In this situation, you must buy the stock and sell the call to restart the strategy.

Stock Prices Fall

StockOption
Purchase Date 1/28/2022Sell Date 1/28/2022
APPLEExpiration 2/18/2022
(19 days till expiration)
Strike Price $160
Purchase Price $170.30Sell Price $12.28

For each contract sold, you’d earn $1,228 ($12.28 X 100).

Stock Appreciation: $16,000 (Strike Price Agreed to Sell) – $17,030 (Purchase Price) = -$1,030

Here’s how to calculate the return yield:

Stock price falls but is higher than $160 on 2/18/2022.

Calculate the rate of return using the following formula:

[Call Option Premium Earned + Stock Price Appreciation] ÷ [Price Paid for the Stock – Call Option Premium Received].

= [$1228-$1030] ÷ [$17030 – $1228].

= 1.25%.

Selling an AAPL Feb 2022 covered calls in the money

In a bearish trend, use a strike price significantly below the actual stock price. This is called “in-the-money.” It means that you’ll get more money right away, but you’ll also have more protection against falling stock prices and more downside protection. In other words, you give up higher rates of return for more downside protection.

Covered Calls: Strategy Summary

Covered calls are an excellent investment strategy for long-term investors in dependable companies. They are a low-risk way to generate extra money from a stock portfolio. A 12–24% yearly return or 1%–2% monthly return on covered calls is reasonable. These returns can be boosted by using leverage, margin, shorter time periods, and riskier stocks. The biggest risk in a covered call strategy is a stock decline. If the market falls, and your stock goes down with it, the losses from a covered call strategy might easily outweigh the benefits. In the worst situation, you lose potential gains beyond the call contract’s strike price.

See also  Update on SDS Buy-Write Strategy Covered Calls

Selling a covered call may be more profitable than owning the stock. However, options trading is not for everyone. Before making any decisions, assess your risk appetite.

Leave a comment

Your email address will not be published. Required fields are marked *