Covered Calls

 We've all heard the saying, "the trend is your friend." This is true when the trend's moving in your direction. Over the course of holding stock, investors expect it to rise over the long term. But keep in mind that stocks rally, pull back, rally, and pull back over and over again. Obviously, if you own a stock, you won't profit when it moves down or sideways in the short term. So what can you do? The answer might be to sell covered calls. By selling a covered call, you could generate a small amount of income and help reduce volatility. In this short video, we'll discuss the basics of covered calls. You'll learn what a covered call is, how to analyze its risk profile, and gain a better idea of whether this strategy is right for you portfolio. Let's start by defining what a covered call is.

A covered is when an investor sells a call option contract against an underlying stock position. When you sell or short a call option, you sell someone else the right to buy your stock at a set price. As part of this deal, you're obligated to sell your stock if the option is exercised. 

Let's look at the risk profile of a short call option to get an idea of the gains and losses involved in this strategy.

The risk profile for a short call shows the maximum profit that can be made if the underlying stock trades below the stock price of the call you sold. After selling the call, time decay works in your favor. With each passing day, a step closer to expiration. Of course, when you sold the call, you also limited the upside potential of the stock for the amount of time you hold the short call. If the stock price rises sharply, you may find that you are assigned, which means you're obligated to deliver your shares.

When combining the risk profile of the short call with the risk profile for owning a stock, it shows the strategies bullish nature but also displays the profit limit. So how do you set up your covered call trade? It depends on whether your desire is to keep the stock in your portfolio or let it go. The strike price you choose will determine the likelihood of hanging on to the stock. If you want to keep the stock and generate a little income, a common approach is to sell and out of the money option. Of course, whenever you sell a covered call, there is the real risk you may not get to keep the stock. If you're not concerned about keeping the stock and what more income, a typical scenario is to sell an at the money option. 

We'll focus on out of the money options that generate a little income while hopefully keeping the stock. Selling out of the money calls may provide room for your stock price to rise before hitting that profit limit. Because of this gap between the call strike price and the stock's current price, you have probability on your side. Odds are that the call option will expire worthless.

Here's a quick example of how you might create out of the money covered call rules in an investing plan. First, use an up-trending option-able stock already in your portfolio or enter an uptrending optionable stock. Next, look at option contracts with 20 to 50 days remaining until expiration. Then, choose an option to sell with a delta of .30 to .40. After selling the call, there are a few guidelines to follow when managing your trade. If there are between four and 10 days remaining, consider buying back the call regardless of where the stock is. If the stock breaks a significant support level, you may want to exit the trade by buying back the call and selling the stock. income from covered calls even if it's a small amount could make pullbacks profitable, or at least less painful.