7. Covered Call

Combining stocks with options

So far we have seen the cases where a trader simply buys or sells options.
Now, let's consider combining stocks with options to make a profit.

Combining stocks with options? I don't get it.

It takes some extra money in your account to use this strategy, but this is a very wise way of trading options. You can make money with this strategy at a very low risk.

Let's see an example of the trade. This time, I'll show you an actual trade of the real market.

(1). Sell a Put

The first step is to choose an underlying stock for which you trade options.
In this example, I picked Research In Motion (RIM) listed on the NASDAQ exchange.

RIM chart
RIM was trading at $62.25 per share on August 24, 2004.
The above chart shows price movements during the past 6 months.
Looks like a real company.

It is.
You begin a trade by selling selling a put on this stock.
There was a put expiring on Octover 4, with $55 strike price and $2.75 premium.

In the real-world market, 1 option contract is worth 100 shares of stock.
If you buy or sell 1 option, you are trading the right to buy or sell 100 shares of the underlying stock.

Really? I thought a trader can buy 1 share of stock in the U.S. market.

You can buy or sell 1 share when you trade a stock directly.
But 1 stock option is worth 100 shares of underlying stock. This is the minimum unit (contract) in options trading.

In this example, let's say you are selling 10 contracts of put with $55 strike price at $2.75 premium.

$2.75 premium means that you receive or pay $275 per 1 option contract.
($2.75 * 100 shares)

So if you sell 10 contracts of this option, you receive $2,750 as initial premium.
($275 * 10 contracts)

See the chart below for a quick summary.

Selling a put
The option is still out of the money at this point.

You're right. The option is out of the money unless RIM price falls below $55.

Now, let's consider CASE 1.
Suppose that RIM price never falls below $55 and the option expires on October 4.

Buyers of the options won't exercise the right in such cases, will they?

Right. The option expires worthless.
You can keep the initial premium of $2,750 as a profit which you gained by selling the options. The trend on the chart indicates a high probability of that occuring. (*)
The U.S. stock options are exercised in "American Style", meaning that you can exersece then at any time before the expiration.

Then, what about CASE 2.
RIM price falls below $55 before the expiration and the options you sold are exercised.

OK, I sold 10 options in the begining, which covers 1,000 shares of stock.
So in that case, I am obliged to buy 1,000 shares of RIM at $55 per share. It's a $55,000 loss in total. Are you kidding?

No I'm not. You are indeed obliged to buy 1,000 shares of RIM at $55 per share in this case. But is this really a loss?


(2). Buy the stock at the strike price

What if you were willing to buy the stock from the beginning?

buying put
Let me see... If I wanted to buy the stock at $55 in the first place, it may be OK to buy it at $55 as a result of the option being exercised.

Additionally, you received $2.75 premium per share when you initially sold the put options.
In total, you ended up buying the stock at $52.25 ($55 - $2.75) per share.

Considering the stock price in past three month, $52.25 seems a fair price to buy the stock. And you should be perfectly happy since you initially wanted to buy it at $55 per share.

Wow! It's better than buying the stock in a way I used to do.

(3). Sell a call to make a profit even more

There is more to it than that.


After you bought 1,000 shares of RIM, you can make a further profit by selling a call option for this stock.

In a bad scenario, for example, the price of RIM may fall from $55 to $50 after you bought the shares. In such case, just sell 10 call options with the strike price of $55 to receive a premium.
And now, you are holding a position with which you can make money regardless of the direction of the stock price.

Sounds great, but I don't understand why that happens.

OK, let's see what happens after trading the options.
First, the calls you sold expire worthless if the stock price falls or stays flat. You gain as a profit all the premium that you received when you sold the options.
In this case, you can repeat the same process and keep selling 10 call options until the options get exercised.

Secondly, if the stock price rises above $55, the options you sold are exercised and you are required to sell your 1,000 shares of RIM at $55 per share.

Remember that you initially bought the stock at $52.25 (in total with the premium of the options) per share. So you get capital gain of $2.75 ($55 - $52.25) per share, and thus $2,750 in this trade. ($2.75 * 1,000 shares. Remember that 1 option contract covers 100 shares of stock, and you sold 10 options, which totals 1,000 shares of stock worth.)
Additionally, you can keep the premium that you received by selling the calls as a profit. It's a great outcome, isn't it?

Covered Call Trading
I see! There is no risk in the exercise of a call option when I hold stocks to cover it, right?

That's right.
A call option that is covered by its underlying asset is called Cavered Call.

As opposed to that, a call that is not covered buy its underlying asset is called Naked Call. In general, it is very risky to sell a naked call.

I prefer not to be naked.

Summary of Covered Call

Let's recap the trade here.
You start out with selling put options on the stock you were willing to buy.
Somehow at this point, you were already in a position where you could make a profit if the stock price goes up, goes down, or even stays flat.

Isn't that awesome?
Investors generally bet on a direction of the market, but I can win a trade no matter what the direction is if I use options.

I need to give you a couple of warnings about the trade we discussed.
First, you need $55,000 to buy 1,000 shares of the stock in your trading account in preparation for the option exercise.
Secondly, you could suffer a loss in total if the stock price plummets 50%, for example, in a short period. In such cases, the option premium cannot cover all the loss of the stock you hold.

Some traders speak of trading coverd call as if it were "trading like bookies", but you do have a risk in all kinds of trading.

That being said, it is true that covered call is a trade with a high winning chance if you choose a right stock and right options.

A strategy like this in trading options is often hard to understand for those who has never traded options. As you get used to options, however, it becomes more natural to you.

Well, trading options is certainly interesting. I'll keep on studying it.