Covered Calls Strategy of How to Write Calls for Maximum Profit

Posted on by Thomas DeGrace

Covered calls strategy
Covered put and covered calls strategy is one the most conservative option related trades. They are also among the most consistently profitable option trades. Studies of the market have shown that around 80% of all option buyers lose money. The inverse of this statistic means that 80% of the option sellers must be making money since for every buyer there has to be a seller. Covered call and covered put strategies take advantage of this condition by making the trader an option seller but limiting risk with an underlying equity position.

What is a Covered Call and Covered Put Trade

A covered call option trade consists of selling a call option for a stock the trader currently holds in his portfolio. The intent is to profit up front from the premium received for the option sold and then deliver stock from the portfolio if the option is exercised by the option buyer. A covered put trade is the inverse of the covered call. Rather than having a long position in the stock, the trader has a short position, and then sells a put option against the short position. The intent of the covered put is to profit from the premium paid for the put option and cover the short position with stock bought via the exercise of the put option the trader sold. Both of these strategies have the potential to provide profit with limited risk. But to realize the best profit with either a covered call or covered put strategy a trader has to match the trade strategy to the current market. Different market conditions will require different trade strategies to maximize the profit with the least risk.

Follow the Trend

The key concept in selecting a covered call or covered put strategy is the trend of the underlying stock. As the old investing saw goes, the trend is your friend. Both covered call and covered put strategies limit risk when making an options trade, but they also limit profit. Consequently these are not strategies to use in strongly trending markets. If a market is strongly trending up the best strategy is an unrestricted long strategy; i.e. buy the stock and/or call options and hold on for as long as the trend keeps going up. Similarly if the trend is strongly down the best strategy is to go short and/or buy puts and wait until a turnaround begins.

The kinds of markets where covered call and covered put strategies are best suited are those without a strong trend. In these markets a covered call or covered put trade can help increase your profits or can even turn a profit where a simple long or short position will not. Covered call trades are best suited to flat to slightly rising markets. Covered put trades on the other hand are best suited to flat to slightly declining markets.

In-the-Money, At-the-Money, or Out-of-the-Money

When making a covered call or covered put trade its as important as the direction and strength of the trend to decide whether to sell the options in-the-money, at-the-money, or out-of-the-money. The risk and profit levels vary significantly based on this choice. An at-the-money option has a strike price equal to or nearly equal to the current market price of the underlying stock. An in-the-money call option has a strike price lower than the current market value while an in-the-money put option has a strike price higher than the current market price. In other words if the option expiration date is reached and the underlying stock stayed at its current value, an in-the-money option would have a cash value equal to the difference between its strike price and the stock’s price. An out-of-the-money option on the other hand would have no value if the stock stayed at its current value at expiration time. An out-of-the-money call has a strike above the current value and an out-of-the-money put has a strike below the current value.

Selecting a Strategy and Making a Trade

In selecting a covered option strategy to use and actually making a trade the first thing to do is determine the direction and strength of the underlying trend. As mentioned earlier if the trend is strongly up or strongly down then a covered call or covered put trade is not your best bet. If the trend is flat to slightly up then a covered call strategy will work. The trade is made by buying 100 shares of the underlying stock and then selling a call option against the long position. You pocket your profit on the option up-front as protection against a slight decline. If you’re confident the stock will rise over the period of the option then selling an out-of-the-money call, with a strike above the market price, will allow you to participate in some or all of that rise, depending on how far out of the money you’re willing to go. However the further out of the money you go the less premium you will receive for the option you’ve sold. If you are less confident on the potential for any significant rise in the underlying stock then an at-the-money trade will bring in more premium but will limit your profit to the upside. A more conservative approach would be to sell an in-the-money call for a high premium but then be prepared to sell the stock at a loss at the lower strike price. The advantage to the in-the-money trade is downside protection by taking profit up front against a future potential decline in the underlying stock price, although overall profit tends to be lower than for an at-the-money or out-of-the-money trade.

If the trend is flat to slightly down then a covered put strategy will work. Understand however that like any short strategy a covered put strategy is riskier than the long strategy of the covered call. If you anticipate only a slight decline of the underlying stock over the short term, then an in-the-money covered call can often provide a small profit despite the stock decline with less risk than the short position taken with a covered put.

To place a covered put trade you first sell short 100 shares of the underlying stock. You then sell an offsetting put option. If you anticipate a significant decline over the short term an out-of-the-money put will let you profit from the decline as well as profit from the premium. If the option is exercised at the strike price the stocks you are obligated to buy will cover your short position at a profit. However like an out-of-the-money covered call trade, the further out of the money you go the less you receive in premium. If you feel the stock will remain relatively steady, with perhaps a slight decline, then an at-the- money put will provide more up front profit in terms of premium received, but will limit the profit on your short sale to the downside. An in-the-money put will provide upside protection with greater premium value received up front but also limits short sale profit with a purposeful loss on the short sale.

You can also combine positions depending on your anticipation for the stock. For example if you’re uncertain how much a stock might rise you can purchase two hundred shares and sell one at-the-money call and one out-of-the-money call. Another tactic if you see a stock stagnating and unlikely to move either direction, is to buy the stock and sell an at-the-money-call. Then simultaneously sell the stock short against the box with an offsetting covered put at-the-money. This will bracket the stock’s position and let you profit on both the downside and the upside. However be prepared to close one trade or the other if the stock starts to move.

Carl R. Moore is an experienced investor in both equities and commodities. Carl is skilled in technical analysis and uses his skills as a software developer to refined his techniques. His current investment approach is focused on covered call strategies for flat to rising markets and covered put strategies for falling markets

2 Responses to Covered Calls Strategy of How to Write Calls for Maximum Profit

  1. SteveB says:

    Like the idea of making money even if the market stays flat.

  2. Terrol P Freund says:

    Can you send me last 6 months covered call record?

Leave a Reply

Your email address will not be published. Required fields are marked *