Covered Calls Explained

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VIDEO NOTES

This is the first video in a short series that explains covered calls. Understanding the content of this video requires at least a basic understanding of Call Options. If needed, before watching this video, you may want to watch the first video in my basic options series titled ‘What is a stock option?.’

While there are different ways to approach covered calls that have different goals, most covered call strategies are income producing strategies.

A covered call is a combination of two positions. The first is a long position on a stock or ETF. The 2nd is a short position on a Call Option.

When one buys a Call Option, they are locking in a pre-set buy price for an asset.
When one sells a Call Option, they are selling their commitment to later sell an asset for a pre-set sell price.

Therefore, placing a covered call means that the trader is buying a stock or ETF, and then selling an option contract that locks in the right for the option buyer to buy that stock or ETF from the trader for a pre-set price.

Let’s look at a hypothetical example to explain.
Let’s say stock XYZ is currently trading for $10 a share. To place a covered call, the trader buys 100 shares of the stock for $10 a share. He also sells a Call Option contract with an $11 Strike Price that expires in a month. He is paid 25 cents a share up front for selling the option.

The trader has bought XYZ for $10 a share. He also sold the right for someone else to buy XYZ from him for $11 a share, and he was paid 25 cents a share for that right.

If the price of XYZ is above $11 a share when the Call Option he sold expires, the trader is obligated to sell his shares of XYZ for $11 a share. He bought XYZ for $10 a share, and he sells it for $11, so his makes $1 a share on the stock. Plus, he was paid 25 cents a share selling the option, so his total profit is $1.25 a share.

If the price of XYZ does not rise above $11 a share before the option the trader sold expires, the option expires worthless. This means that the trader keeps his stock, plus he keeps the 25 cents that he was paid up front for selling the option as profit.
The next month, he can sell another option and repeat the process

The risk for a covered call trader is that the price of the underlying stock makes a large move downward. The premium that the covered call trader collects somewhat helps protect the trader against a downward movement of the underlying stock.

When placing a covered call, a trader must choose which stock or ETF to buy, and which Option to sell on that stock or ETF, There is there is a trade-off between potential profit versus downside risk. For each Option the trader could sell, the trader must consider the cost of the Option, in other words the amount he would collect up front, the price at which the option is exercised, in other words, the Option’s Strike Price, the amount of downside protection that the Option provides, and the break-even point.

Therefore, the selection of which stock or ETF to use for Covered Calls, and which Call Option to sell on that stock or ETF depends on the strategy and goals of the trader.

In the next video, we will look at examples of covered calls. I hope that you enjoyed this video. Thanks for watching

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