Taking Worst Case Scenarios of Selling Covered Calls – It’s Not That Bad!

While I am new to the options game myself, I have learned quickly that options are like stocks, but on steroids.  In this article I’m going to cover a simple options strategy, selling covered call options.  Before diving too deep, please make sure to read our Trading Options for Beginners Guide to familiarize yourself with the different type of options.

One of the simpler and more popular options strategies is a covered call.  Now, what exactly is a covered call?

A covered call consists of two different components; the first component being that you own at least 100 shares of the stock you are looking to cover.  The second component being that you sell one call option against the shares that you currently own.

Not to veer off topic too much, but please keep in mind, selling a call option without owning any of that specified stock is extremely risky!  There is an a loss potential of 100% (if the stock goes bankrupt), for a fixed gain potential.

So then what is so appealing to the covered call option? 

The biggest reason is that if the stock price does rise above the called strike price, you can then collect the premium for selling the call, and additionally sell your 100 shares for a profit.  In essence, you are able profit in two different ways. 

Additionally, with a covered call option you can still profit in scenarios even if the stock price would drop slightly.  Let’s not forget the greatest upside to a covered call option, should the market cooperate, the investor can keep selling calls under the strike price to create a stream of monthly income

I’ll be sure to show examples below!

Selling a Covered Call – Profiting from Premium [Example]

Example 1 – Making a profit below your strike price

  • Initial Stock Price $AXP: $108.25 (on 3/7/20)
  • Cost to trade: 100 shares = $10,825
  • Sell the 27th Mar $125 call for $0.59 (per share/option)

Remember that 1 options contract represents 100 shares. So selling 1 covered call contract will give you $59 in premium ($0.59 x 100).

In this example, your “break even” (BEV) is if $AXP drops to $107.66 per share, which would still be below the $125 strike price. 

In this case, the covered call itself would expire worthless because the final price is less than the $125 strike price. 

The guy on the other side of the trade (who bought your covered call) wouldn’t want to exercise the call option because then he would be taking your 100 shares and paying $125 each for them when they’re currently only worth $107.66 per share.

If you sell your shares at this point, your trade would break even because your loss on the stock would be offset by the premium you received– $59 in premium offset by the 100 shares you bought at $108.25 ($10,825) now worth $107.66 ($10,766) = $59 – $10,825 + $10,766) = $0.

So, how can you turn this into a long-term monthly cash flow? Well, you don’t have to sell the stock and lock in your loss in this case.

If the call option stays below the strike price and it expires worthless, you still have the 100 shares and you can continue to keep selling call options.  If you find a stock that stays in business for a very long time, this can be a solid option for a low, but steady rate of return. 

Eventually this process will come to an end once a call option you’ve sold hits or exceeds the strike price of the call option.  Remember, in that event you must sell your 100 shares at that strike price. But… then you can always re-buy 100 shares if the stock is still at a favorable price, and restart the process all over again!

More Downsides of Selling Covered Calls

As with anything, there are a few quirks of a covered call that make them not as attractive.  The biggest one in my opinion as a young investor is the high cost associated with the strategy.  Not only do you have to buy the call option premium, you must also purchase or previously purchased 100 shares of the stock, which can get expensive quickly. 

In today’s market I would consider $40 an average stock price.  This strategy on a $40 stock will cost you ~$4,000 or more per trade.  You will be spending $4,000 on the stock ($40 x 100 shares)..  Trust me you aren’t the only one who is thinking, “Who has $4,500 laying around to start trading options.” 

In that case, if your capital is limited I’d recommend a dividend strategy that allows you to start with little capital, and be patient while your wealth grows over time!

The good news is, this should be a stock you are familiar with and comfortable owning either way, which does make the pill easier to swallow on the large up-front investment (similar to the reasonable downside you receive for selling covered puts).

The second downside to a covered call is you are limiting your gains.  In a covered call, you are required to sell your stock once it hits the strike price of your call option.  In return for getting your premium back, you limit the upside on your trade. 

That means if your strike price is $15 higher than the current trading price, and the stock surges $50 in 30 days, you have a lost opportunity of $35 per share, totaling $3,500 for the specific trade.  Now, keep in mind that is a first world problem, as you would have also profited $1,500 + the premium of your call option.

Now, let me show you a full example of this scenario playing out.

Example 2 – Only owning the stock:

  • Share Purchase Price: $100 per share
  • Share Price Change: $100 to $150 per share
  • Share Sale Price: $150

In the simple example above, you would profit $50 per share, multiplied by 100 shares for a $5,000 profit.

Opportunity Cost from Selling a Covered Call [Example]

Now, how a covered call could hurt you in this situation (in the sense that you miss out on greater potential gain).

Example 3 – Covered call:

  • Share Purchase Price: $100 per share
  • Call option purchase: $110 strike price for $0.60 (30 days)
  • Share Price Change: $100 to $150 per share
  • Shares Sales Price: $110 (Call Option Strike Price)

In this example, after 30 days you would profit $10 per share for selling at the strike price (stock goes from $100 to $110), for a total gain of $1,000 ($10 per share x 100 shares).

Additionally you would also collect the $60 premium for selling the call option ($0.60 x 100).  Your total profit here would be $1,060.  Hey that is great! Right?  Well, you actually “cost” yourself $3,940 by using the covered call strategy, because the stock went to $150 and you could’ve made $5,000 by simply buying 100 shares at $100 and selling at $150.

This is definitely a pessimistic viewpoint but can happen especially if breaking news (good or bad) on the company hits in the 30-day call period.  However, in the long run this is a very viable and safe strategy.  My father once told me, “Slow and steady wins the race”.

This is just the beginning on options strategies, but I wanted to start with one that was a little less risky for someone just starting to trade options.  Please keep in mind this these are some of the basics to the strategy and there are more complex mechanisms to consider, which we plan to cover in future posts.

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