The Covered Call Stock Option Strategy

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A popular stock option strategy used by investors is the covered call. The covered call is one in which you would write a call option contract for a number of shares of stock you actually own. If you own the stock before writing the call option it is called an overwrite. If you buy the stock as you create the call contract, it is called a buy-write.

 

The stock you own is covering the call option contract which is where the name is derived from. This stock option strategy is generally used when the market is going sideways or you form an opinion that a bull market is developing.

 

With the covered option, the price for the underlying asset has been determined already unlike in a naked option where you don’t own the stock. When the option is uncovered, you will have to go to the market to buy the stock if and when it becomes necessary to cover the option. It is possible to cover your option at any time before the expiration date of the option contract.

 

The covered call stock option strategy is less risky than the uncovered option simply because you already know the price of the underlying asset. The covered call is used to generate income from the underlying asset or stock.

 

You get to keep the premium on the covered call and if the contract expires then you also profit from any gains in the stock value. If the option is exercised you will earn the premium in addition to the difference between the purchased stock price and the strike price. This stock option strategy can also protect you from underlying stock that that may experience a price decline.

 

The breakeven point for the covered call stock option strategy is equal to the stock purchase price less the premium received.

The Covered Call Option Strategy

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Covered call is an option strategy which is created when an investor hold a long position in a stock and write call options on that same stock. This strategy is used when you think that the stock is bullish but it will have limited price change during the option life. When writing call options you will get premium which will increase your return when the stock does not move a lot or when in consolidation. This strategy will give you the benefits of underlying stock such as dividend and voting rights.

Covered call has limited profit and very high loss when the stock drops to 0. Maximum profit will happen when the price of stock is at or above the call option strike price. Your stock loss will be offset by the premium you get when writing call option.

Here’s an example for you to understand it more. You bought stock ABC at $50 and write a call option at strike price $60 for $5 premium.

There are 4 final results:

Stock ABC price is below initial purchase price at $40. Your loss from the stock will be $10 and it will be offset by the $5 premium. So you total loss is $5.

Stock ABC price is above initial purchase price but below strike price at $55. Total profit from stock and $5 premium will be $10.

Stock ABC price is at strike price at $60. Total profit from stock and $5 premium will be $15.

Stock ABC price is above strike price at $70. Your total profit will be the same like when it is at strike price which is $15.

 

The Basics Behind the Covered Calls

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Despite the popular notion that is constantly being perpetuated by the mainstream media not all options trading strategies place an undue amount of risk on an investor’s portfolio. It certainly is true that many speculative techniques, such as selling naked calls and puts, increase your overall risk, there are numerous option trades that are not only safe, but are also moderately conservative. Perhaps the most widely used option strategy available to the average investor is selling covered calls.

The buy write strategy, as selling covered calls is also known as, is a relatively straight forward and simple technique to execute. As the seller the only thing you really must have is at least 1000 shares for every call option you want to sell. This is important since each option contract controls 1000 shares of the underlying asset. Additionally, selling a covered call gives the purchaser the right to buy a certain number of shares of stock at a certain price as long as the buyer actually exercises his or her right to do so.

As compensation for selling these options the seller receives payment, called a premium, from the buyer. This income stays with the seller regardless of the ultimate direction the underlying stock takes. It should be noted that the buyer has the right to buy the stock yet is under no obligation to do so. In fact, approximately 75% of all option contracts that are held until maturity expire with no value. Savvy investors know this and are constantly looking for ways to use covered calls to turbo charge their investment returns even in neutral or slightly declining markets.

Perhaps the most important part to this entire investing technique is that the seller actually owns an appropriate amount of stock to cover them in the event that the price of the underlying stock closes above the option’s strike price. If the investor did not own the underlying stock, and the options were executed, he or she would have to actually go out into the open market and buy a sufficient number of shares at the current market price to cover their obligation.

As there is no cap on how high the price of a stock can rise the investor would be exposed to an almost unlimited potential liability. It is, therefore, highly recommended that intelligent investors stick with covered call strategies as their option trading technique of choice.

Bull Put Spread: Trade Example

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This is a past recommendation on PBL which demonstrates how the bull put spread strategy works in real life.

Trade:

Bull Put Spread

Sell 10 PBL39 Oct 1950 Puts @ 22

Buy 10 PBL36 Oct 1900 Puts @ 12

Net Credit = 10 cents

This trade requires minimal margin requirements.

Maximum Profit

The ideal result is for both options to expire worthless, so that maximum premium is retained from the credit spread.

= Net Premium Received

= Sold Put Premium – Bought Put Premium

= (0.22 – 0.12) x 10 contracts

= $1000

Maximum Loss

This will occur if the share price is below the bought at expiry

= Difference between strike prices less net premium received

= 50 – 10

= 40

= 0.40 x 10 Contracts

= $4000

Breakeven

Upper strike less net premium received

= 19.50 – 0.10

= 19.40

Main Benefits of Strategy

1. Provides leveraged exposure to a rise in the share price

2. Takes advantage of time decay

3. The ideal result is for the options to expire worthless, which means the client will save on brokerage not having to close the position to take a profit.


To receive ASX Option Recommendations or to learn more about Bull Call Spread, Bull Put Spread, Bear Call Spread, Bear Put Spread Strategies please request the Option Spreads eBook by contacting us on 1300 368 316 or info@totaloptions.com.au

Bull Put Spread vs. Sold Put

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A number of advantages are evident when trading bull put spreads compared to selling puts (naked puts). A bull put spread has considerable lower risk than just selling a put which has a much larger risk. The bull put spread has a much better risk vs. reward than selling naked puts. Selling puts can have benefits when combined with portfolios that can help produce income and purchase stock below market value. This strategy is detailed in the Income Strategy E-Book and will be available later in the course.


To receive ASX Option Recommendations or to learn more about Bull Call Spread, Bull Put Spread, Bear Call Spread, Bear Put Spread Strategies please request the Option Spreads eBook by contacting us on 1300 368 316 or info@totaloptions.com.au

Bull Put Spread: Strategy Risks

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It is important to always be aware of the strategy risks. The primary risk when placing a bull put spread is when the share price decreases past the sold put and an ever greater concern is if the share price decreases below the bought put (protection). Since you receive a premium to enter this trade there is a required margin. This margin can increase to as much as 1.2 times your maximum loss. For example if you were risk $2,000 the cash margin required in the account can increase to $2,400 (2000 *1.2) which includes the premium received. So it is important to know your maximum risk and make sure there are enough funds to cover the worst case scenario.

Another risk inherent with selling options is volatility. When you open the bull put spread you want the volatility to be high so you can sell the put options for as much value as possible. Once the trade is placed you want the volatility to drop off and time decay to kick in. So even if the share price stays still but volatility increases the position may not profit in the short-term. Increased levels in volatility mean to close out it will cost more to buy back the sold put. If the share price decreases below the sold put prior to expiry there is potentially a risk of exercise.

Exercise

The main risk of credit spreads is the risk of being exercised. If the sold put is exercised it means that you are obligated to buy shares at the exercise price of the sold put. This can have a negative impact in terms of you have bought shares you do not own which means you need to sell them back at the lower level and therefore locking in a loss on the share position. If the share price is below the bought put (protection) when exercised then you can sell the put option which will reduce the loss from being exercised. It is still not possible to lose more than the maximum risk before entering the trade. Another disadvantage of being exercised is the brokerage on the share purchase and sale so it is a good idea to try an avoid exercise. To avoid being exercised you need to monitor your position and more importantly the delta on the sold put. If the share price is below the sold put an indication of the likelihood of being exercised can be identified by the delta. If the delta on the sold call is below -0.95 there is a chance being exercised. If the delta is below -0.98 then it is necessary to implement one of your exit strategies.

To avoid exercise there are two options. If you think the share price will keep decreasing you can close the trade for a loss. If you think you view is correct and the share price will rise from this level and want to keep the position you can roll out to the next month. What this means is you can close the positions you have an open the same position for the next month and do this for no cost or a small credit. Therefore if the share price then increases above the sold put by the next month you can still make maximum profit.

To receive ASX Option Recommendations or to learn more about Bull Call Spread, Bull Put Spread, Bear Call Spread, Bear Put Spread Strategies please request the Option Spreads eBook by contacting us on 1300 368 316 or info@totaloptions.com.au

Bull Put Spread: Trade Analysis – Risk vs. Reward

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Trade Analysis

Analysing your trade is essential before placing the trade. You need to make sure you have the necessary detail and go through the following checklist:

  1. Stock Selection: Double check your analysis on the stock and make sure your outlook on the share price reflects the bull put spread.
  2. Determine max loss and check that that is suits your risk profile and how much of your trading account you are risking.
  3. Determine premium received when entering trade, most important as it is also your maximum profit.
  4. Make sure you risk vs. reward suits the trading strategy.

Risk vs. Reward

The risk vs. reward will be different for every strategy. Credit spreads have a lower risk reward meaning the maximum profit (reward) is quite low relative to the maximum loss (risk). This trade can be positioned to risk $0.50 to make a $0.50 this is when the bull put spread is traded at-the-money. The trade can be more cautious by selling out-of the money options where you risk $0.80 to make $0.20. Both trades work well at the right time but the first example only requires a 50% success rate to break even while the second example requires an 80% success rate to break even.

Author: Matthew Gartrell

To receive ASX Option Recommendations or to learn more about Bull Call Spread, Bull Put Spread, Bear Call Spread, Bear Put Spread Strategies please request the Option Spreads eBook by contacting us on 1300 368 316 or info@totaloptions.com.au

Bull Put Spread: Identifying Trades – The Greeks

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Delta

When identifying trades it is essential to look at the delta of the option legs. In particular it is important to calculate the net delta of the bull put spread. The net delta is calculated by the delta of the sold put option minus the delta of the bought put option. The net delta will always be negative. The net delta indicates if the share price increases quickly what the value of the bull put spread will be worth. For example, if a bull call spread had a net delta of -0.20, and the share price decreased by $1.00, the bull put spread would have decreased by 20 cents. Therefore to close out the position you buy back the position for less than the premium received to enter the trade.

 

Vega

The volatility affect on a bull put spread is positive. When looking to enter a bull put spread you look to sell an out-of-the-money put option. The idea is to sell a put option which has a relatively high volatility and therefore trading above its theoretical value. The bought put even further out-of-the-money and you want to buy this option with low volatility. When entering the trade you want to volatility to be high and decrease throughout the trade.

 

Theta

Credit spreads are set up to take advantage of time decay. The effect of time decay on this strategy varied with the underlying share price level in relation to the strike prices of the long and short options. If the stock price is midway between the strike prices, the effect can be minimal. If the stock price is closer to the higher strike price of the sold put, profits generally increase at a faster rate as time passes. Alternatively, if the underlying stock price is closer to the lower strike price of the bought put, losses generally increase at a faster rate as time passes.


To receive ASX Option Recommendations or to learn more about Bull Call Spread, Bull Put Spread, Bear Call Spread, Bear Put Spread Strategies please request the Option Spreads eBook by contacting us on 1300 368 316 or info@totaloptions.com.au

Bull Put Spread: Option Pay-Off Diagram

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It is essential to understand the option pay-off diagram for the option strategy you are trading. It allows you to know to determine at what share price you achieve maximum profit, maximum loss and breakeven level at expiry. The bull put spread is made up of a sold put and a bought put at a lower strike. When combined it creates a bear put spread. See below for how the bull put spread option pay-off diagram is constructed. The dotted green line is the sold put and the dashed green line represents the bought put.

Bought Put


Sold Put


Bull Put Spread


To receive ASX Option Recommendations or to learn more about Bull Call Spread, Bull Put Spread, Bear Call Spread, Bear Put Spread Strategies please request the Option Spreads eBook by contacting us on 1300 368 316 or info@totaloptions.com.au

Bull Put Spread: The Strategy

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A bull put spread is a moderately bullish option strategy that profits when the underlying share price stays still or increases. A bull put spread is similar to a bull call spread. The bull put spread involves simultaneously selling of a put option at a strike price while also buying the same number of put options of the same asset but at a lower strike. A bull put spread is also a technique to selling naked puts but buying lower puts to reduce the maximum loss. Because the bull put spread is a credit spread, you also make money if the underlying asset does not move through time decay. The bull call spread, on the other hand, would not be able to profit if the stock did not move upward beyond its breakeven point.

Maximum Profit

To achieve maximum profit the share price must be above the sold put strike price at expiry. The maximum profit for a bull put spread is the net credit received.

Maximum Loss

If the stock price decreases below the bought put at the expiration date, then the investor has a maximum loss. The maximum loss is the difference between the sold put and bought put strike price less the net credit received.

Break Even

The breakeven is higher than just selling a put; however the maximum loss is reduced significantly. The break even point is the strike price of the sold put minus the net credit received.


To receive ASX Option Recommendations or to learn more about Bull Call Spread, Bull Put Spread, Bear Call Spread, Bear Put Spread Strategies please request the Option Spreads eBook by contacting us on 1300 368 316 or info@totaloptions.com.au