Looking at a covered call strategy, the big goal behind it is to make money every month. You could do it every 30 days, 45 days or whenever you decide. It’s totally up to you. Above 60 days, you could do it but this theta decay is a little slower.
Options do decay
That’s what you’re really doing is you’re selling insurance on your stock. So in order to execute this strategy, you have to start out with 100 shares minimum of stock.
One option contract controls 100 shares of stock.
What you’re going to do is you’re gonna sell one call contract while you have 100 shares of stock. Get it close to 30 days when the acceleration is really quick and it decays.
Now you’ll make more money if you go further out but the decay is slower. In 30 days, you can get wider but in 60 days, you’ll be tighter to your strike price. There’s always trade-offs.
Normally you make money as the stock goes up, you lose money as the stock goes down. With this strategy, you’re gonna be adding in a little flat and curve.
Let’s say your current price is right here.
Eventually a stock price goes up and then if it goes too far past the premium, you just lose your stock but still keep the premium. You lose your stock at a higher price. When you have a hundred shares of that stock, then you sell premium on it month after month.
Eventually, it’s gonna go past that premium price and when it does, you’ll lose your stock but you get money for it. In other words, you sell it at that higher price but you’ve continued to collect that premium month after month.
We know that stock prices don’t go up really forever. Let’s just do Twitter and just to give you an example right here.
Twitter is $29 right now. So I need to buy a hundred shares of Twitter to make this work. This is what the profit risk profile picture looks like.
Here’s your profit and loss.
Here’s your zero line and my current price.
Here is the price of the stock.
Normally you just make money as the stock price goes up but these things don’t go up forever, sometimes they pull back.
Wouldn’t it be nice to make money every single month? That’s what the covered call strategy does. These option contracts right here.
You’ve got calls on the left and puts on the right. The whole goal is selling these things. Right now the current price is $29 on this stock.
If I sell it at $31, chances are I’m gonna lose my stock.
Do you want to sell this thing every single month and make money and still keep your stock?
Or are you okay if the stock gets sold at that higher price, you’ll just rebuy it again and continue to do this for the rest of your life? You could do that as well.
So it really just depends on what your end goal is. Let’s say that you don’t care if you lose the stock. You could look at something of a probability of 10 percent worth at expiration.
If you’re not that worried at all, you could go at 25 percent. You’ll see these percentages right here. I’ll sell sell a single and you’ll see that I get 48 cents for that.
This flatten out my curve. The strike price I’m selling it is at $31 dollars on December 20th 2019.
That means if the stock is above 31 dollars at that time, I’m gonna lose my stock.
The great thing about this is I’m still gonna make a profit from the stock. If that stock stands still, what’s gonna happen is I get to make 48 bucks to the call that I’m selling. It doesn’t seem like a lot but let’s say you multiply this times 10 contracts and you have 1000 shares.
All of a sudden, you make 480 dollars if that stock didn’t hit 31 dollars a share.
That’s great!
The problem with just selling naked calls is that losses can continue to accelerate that’s why you have the stock. So when you have the stock right here.
I sell it at 31. If it goes to 30, it’s still under my 31, I still make my 480 dollars. If it goes to 33, I still make my 480 dollars but my I lose my stock at that $31. I could have made probably a little bit more but you can’t win them all. Then you go ahead and just keep your stock and you do this again in January. You continue this process then you do it again in February and March.
That’s really the way the covered call strategy works. If you look at that profit picture and it looks just like this.
There’s gonna be an alternative.
If the stock price goes down, let’s say down to 28, at least you made $480. You could see my losses would be right around 898 with the calls.
If I didn’t have it at 28, I would lose about a 1,176 dollars.
That’s the other advantage with selling covered calls.
Even if your stock pulls back a little, it cushions you.
- You make money from if the stocks stand still.
- It cushions you if the stock pulls back a little.
- If it goes up just a little bit you still get to keep your premium and keep the stock.
- If the stock does explode, that’s kind of where this doesn’t work out.
In that case you lose your stock at the strike price but you still get to keep the premium. You’re still winning. You just lose the stock, you can rebuy it and do the process again.
If you want to really really keep the stock, what you can do is go really far out.
You get less premium at these prices. If you’re not worried about it too much, you could sell closer.
You make more money but chances are you’ll probably lose your stock. Some people do this in about for 12 months. Let’s say eight months of them were a win and they keep the stock. Then the other four months they still got the premium but you lost this stock.
Sometimes it could work out that way just depending on where you’re selling depending on the market. Nevertheless, you’re making extra money and income. This is a great alternative if the stock isn’t paying a dividend. It’s kind of like making a dividend if the stock is paying a dividend by doing this strategy.
Here’s an alternative: Notice this profit picture.
If we buy a diagonal, what you’ll see is that this is a very similar strategy. You still have an upward direction and then you have a flattening of that curve.
It uses a lot less capital. So here I’m putting on a trade for $80 compared to buying a thousand shares of Twitter at $25 is much more.
Now you could see hey that’s actually very close. I could just risk about $360 on that trade and look at the profit picture.
It looks very similar to the profit picture of this by using less cash. By just dealing with the options themselves. You can see right there the power behind it.
