Covered Call: The Option Strategy That Everyone Uses
Definition of a Covered Call
n. A short call option covered by 100 shares of the underlying equity. An investor enters a covered call position by selling a call option after buying 100 shares of the underlying equity.
Nothing triggers my FOMO like selling covered calls on my favorite stocks.
Related Terms
- **Long Call: ** Buy a call option to open.
- **Short Call: ** Sell a call option to open.
- Buywrite: Buy 100 shares of the underlying equity and sell (write) one call option in the same order.
- Naked Call: Sell a call option to open without owning shares in the underlying equity, which is very dangerous.
- Called Away: Your shares are sold to the option buyer when they exercise the call option and buy the shares from you at the strike price of the call option.
TL;DR
- Covered calls can enhance your portfolio returns especially in sideways trading and down markets and can provide outsized annualized returns (see example trade below).
- If you want to sell call options, the covered call is the way to do it. Selling a naked call option requires elevated approval from your brokerage and is subject to unlimited losses.
- Sell it and forget it. Covered calls are one of the easiest option positions to manage.
- Covered calls are prone to trigger FOMO because they cap the upside potential of the owned stock. Although there are ways to mitigate this fear, it is a powerful force that turns investors away.
Real Example of a Covered Call
Nordstrom (JWN) is a retail powerhouse of a company. JWN is trading at $19 as of close 9/9/2022. I can sell a $20 strike call option for $1.02 expiring Oct 14th in 35 days. The return on that if JWN just trades flat the next month is $100/$1,900 (the capital required for 100 shares) = 5.2%. That's an annualized return of 54%! On top of that JWN pays a dividend which I'll also collect if I continue holding the shares and selling covered calls. This is a trade that can simply be repeated until the shares are called away.
What's the worst that can happen?
Let's keep going with the Nordstrom example from above. Once the call option is sold short, there a few things that can happen. We're interested specifically in what happens around the time that the option expires, its expiration date.
The stock trades sideways
If, on expiration, the stock price hasn't moved much, then the option price will have fallen and it will likely close out of the money. In this case you keep the premium that you sold the option for and can repeat the trade.
The stock price goes through the roof
You will be assigned and your shares will be called away. Your brokerage account will automatically be credited $2,000 (because the strike price was $20/share * 100 shares). The return on this trade is the initial credit of $1.02, plus the rise in the price from $19 to $20 per share for another $100. The total return therefore is $202/$1,900 = 10.6% in just 35 days.
You do however, miss out on any stock price movement above the $20 strike of the option contract and this is the cause of FOMO that prevents investors from wanting to sell call options. If you suffer this FOMO, then an options trading bot is just what you need! It doesn't hope for a moon shot short squeeze, it sells options; perpetually.
The stock price goes through the floor
In this scenario, you're losing money on holding the 100 shares of stock. However, your option will go to zero very fast and so you're losing $102 less than if you hadn't sold the option.
Tiblio AI Approach
The bot will confirm that you have at least 100 shares that aren't paired with a short call option. Next, it searches and finds an option suitable to sell according the configuration settings that you chose. Finally it will make sure that it isn't selling an option below your adjusted cost basis in the shares.
If everything checks out, the bot submits an order to sell the option. It then monitors the order for several minutes and will adjust the price to get the order filled.
Once the option expires, the bot will sell another one and will continue that until the shares are called away. At which time the bot will sell put options (Cash Secured Puts), if configured to do so.