Covered Calls For Beginners
Options trading for beginners can be daunting. Experienced traders forget what it was like before they knew option lingo. This article is for covered call beginners who want to learn what covered calls are and how to write them to generate recurring monthly income.
Covered calls are the simplest option strategy, and the one that most beginners learn first. But, you do need to learn a few terms. At a minimum you need to understand call vs. put, and covered vs. uncovered. As well as the fact that each option contract (a "call option" or a "put option") controls 100 shares of stock (this will be important later).
There are 4 combinations: covered call, covered put, uncovered call, and uncovered put:
Call Option
A "call option" (or just "call" in the context of investing) is a contract that gives the buyer the right to buy stock at a certain price before a certain date. The price is called the "strike price" and the date is the option's "expiration date". Example: You own a Jan 19, 130-strike, AAPL call option. That means you have the right to buy 100 shares of AAPL at a price of 130 any time between today and Jan 19.
Short Call Option
If you own the option, then you are "long" the option. Just like with stock. If you own 100 shares of AAPL then you are "long AAPL". Sometimes you don't own an option. Sometimes you sell an option to someone else. Now you are "short" the option. When you are short a call option you have agreed to deliver stock if the option holder (who is long the option) asks for it. It's his "right" to ask for it; it's your "obligation" to deliver the shares if asked.
Put Option
A put option is the opposite of a call option. It gives the buyer the right to sell stock at a certain price by a certain date. Example: You own a Jan 19, 130-strike, AAPL put option. You have the right to sell 100 shares of AAPL at a price of 130 any time between today and Jan 19. Buying a put option is like buying insurance for your stock. You know you can put the shares to someone else for the strike price, no matter what the stock price.
Covered Options
A "covered option" is one where you own the underlying security corresponding to the short option. It can be a covered call or a covered put.
If you are talking about 1 call option on AAPL that you were short, you would need to own 100 shares of AAPL in order to make it a covered call option. If the option holder requests the 100 shares (as is his right, since he is long the call option) then you already have the shares needed for delivery. That's what makes it "covered".
You can also have a "covered put" but since it's the right to sell, if you were short a put option then you would be short the shares in order for the short put to be considered "covered". This is more advanced than a covered call beginner's strategy needs to worry about, so we're going to skip covered puts in this article.
Uncovered Options
Uncovered options are where you are short the option but do not have an offsetting position in the underlying stock to "cover" your potential option obligation. Many traders use these but they are too risky for beginning option traders so we will skip them for now.
For further reading: once you understand covered calls (and have made a few trades with them), you should study naked puts (aka "uncovered puts" or "cash secured puts (CSP)"). They have the same profit and loss graph of a covered call but conceptually are a little different. See Naked Put vs. Covered Call for more info.
A Beginner's First Covered Call
Now that we have the lingo out of the way, how do we actually trade a covered call?
First buy 100 shares of a company you like. It's important that you like the company, because you may own these shares for a while. Let's say XYZ is trading at 19 and you buy 100 shares for $1900.
Second, sell 1 call option (not 100 call options, because each option controls 100 shares). You can pick the expiration date and the strike price. The expiration date will be some future Friday (unless that Friday is a holiday where the market is closed, in which case it will be the Thursday before). The strike will be almost any number you want and should be the price per share you're willing to sell your shares for on the expiration date you've chosen.
Let's say you are willing to let your stock go for 20 (remember, you paid 19) within 2 weeks. You sell 1 call option with an expiration date 2 Fridays from now and a strike price of 20. Let's imagine you receive 2 for the call option. That means $2/share, and since it controls 100 shares (like all options) you will receive $200 cash in your account on the day you sell the option.
Now you are long 100 shares of XYZ at 19, and short 1 call option against those shares. Congrats. You now have a covered call. Prepare for greatness.
So Now What Happens?
We wait until expiration day. On that day one of two things will happen: (1) the option will expire worthless, or (2) the option will be exercised (also known as "assigned") to you.
If the stock price of XYZ is less than the strike price of your call option (20) then the option expires worthless. You keep the $200 you got at the beginning, and you keep your shares. The following Monday you can repeat the process and sell another call option against those same shares. You can keep doing that until they are called away.
If the stock price of XYZ is greater than the strike price of your call option (20) then the option will be exercised against you. That means you will have to give up your 100 shares and accept $20/share cash as payment. But don't worry, you've still made a profit. You only paid 19 for the shares, and now you've sold them (well, had them called away) for 20. You made $1/share. Plus you got $2/share for the option, so you really made $3/share over the 2 week period.
What if XYZ stock price is very close to the strike price on expiration day? Will it be exercised or not? The answer is: It depends on the option holder. It is their right, but not their obligation, to exercise their option if they choose. When the closing price on Friday is near the strike price, some option holders will choose to exercise and some will not. For more info, please see Will I Be Assigned?
Other Resources For Beginning Covered Call Investors
We have a writing covered calls tutorial for beginners. And we have a resource page where you can learn options more thoroughly than we can describe here. If you're feeling ambitious, you can read more about Time Decay In Options (which just means the price of options goes down over time, all other things being equal).
Mike Scanlin is the founder of Born To Sell and has been writing covered calls for a long time.