Why aren't you using this options trading strategy?
Plus, a guide for small accounts on how to immediately implement this set of tactics
This service is for general informational and educational purposes only and is not intended to constitute legal, tax, accounting or investment advice. These are my opinions and observations only. I am not a financial advisor.
Choosing the right options trading strategies and learning to trade them well is key. Often it is the strategy that causes problems. More specifically, finding the right strategy for your personality and style takes time.
There is an approach that allows you to use and learn options while locking in 3-5% gains immediately with no risk of losing money on the option contract itself. The strategy is the opposite of what most new traders try to do. The strategy is selling options instead of buying them.
The Covered Call Options Strategy allows you to take positions (buy shares) in growth stocks and earn immediate premium (cash) by selling call options against your shares. I’ll get into examples from my portfolio to provide some detail on how it works.
Really?!? Only $500 Invested and Instant Gains?!?
A mistake often made by small accounts is to take an initial $500 or $1000 or more, dump it all into a handful of options trades, either calls or puts, and try to sell them at a profit using a newly learned strategy.
After a few initial ups and downs, you find yourself staring at a zero balance again. More money is deposited and there are more attempts and failures as the learning process takes some time. Eventually some find the right strategy and become successful but only after paying a very expensive “tuition” for learning.
You can avoid using your money to pay this tuition while still trading options and learning hands on by using the Covered Call Strategy. Use options to create the capital you need to trade options. It’s that simple.
The stocks could remain flat all year, but you will collect roughly 3% for every call you sell.
There is still risk involved, but it is more easily managed, and your initial option position is always adding to your available balance. This is because you’re selling the option and collecting premium. There is analysis and work to be done before you dive in, but the simplicity of the Covered Call Strategy is also one of the benefits.
This past week I collected $90.05 in premiums selling options against three positions, DKNG, RKT, and SOFI. My total investment is $2,383.27 and immediately I’ve earned 3.8% ($90/$2,383) collecting cash from the calls sold. I have also given myself the potential to repeat the process over and over.
Another way to look at this is I’ve given myself a 3.8% cushion before I take any losses from a drop in stock price across these three holdings. How? If the stocks move sideways or drop in price the calls also become less valuable and continue to decline until they reach zero upon expiration which means I keep the entire $90. The cushion.
This allows you to take a 3.8% hit to the stocks before taking overall real losses to your portfolio because you’ve added the $90 from selling calls. Playing this out further, if the stock only rises slightly, remains flat, or drops between the time you sell the option and expiration of the option you will be able to repeat the process and sell another call against your shares. The stocks could remain flat all year, but you will collect roughly 3% for every call you sell.
If you’re interested in tracking the progress of my portfolio you can sign up for free at Savvy Trader: Covered Call Strategy Portfolio by Trader Nate
Also be sure to follow me on Twitter @tradernatehere for daily posts on trade updates and trading strategies.
How the Covered Call Strategy Works
When you are implementing the Covered Call Strategy you are selling a call option while simultaneously owning the shares of the underlying stock. This means you are creating a ceiling for the maximum amount you can make on the stock over a period of time.
More specifically, you can only make the premium collected plus the exercise price of the option. If the stock explodes to the upside, you cap out at the strike price.
Using RKT as an example, I bought 100 shares at $7.46 for a total of $746. I turned around and sold a call with an $8.00 strike price and February 17th expiration. If the stock moves to $9 (a 20% gain) I will only realize the $8 price plus the $33 premium collected for selling the option. However, that “only” is still 11.7%. Not bad.
This brings up another important point. If you are unable or unwilling to sell your shares of stock, you should not use this strategy. You must be able to sell the shares you own without any repercussions or care. You’ll be able to buy them back or more likely, find the next stock to work the Covered Call Strategy with.
RKT Call Option if Exercised at $8 strike price, Originally collected $33 premium
$8 x 100 shares = $800; $33 premium collected = 4.4%
$800 + $33 = $833 maximum total value
$833 - $746 purchase price = $87 profit = 11.7%
As a reward for creating a ceiling for profits, you are paid a premium for selling the option which should be included in your overall profit calculation (as shown above). I was able to collect a 4.4% premium against my 100 RKT shares.
The RKT example highlights that despite giving up a chance at a 20% gain in the next 44 days, the Covered Call Strategy would still earn an 11.7% gain should the stock really take off while also providing the support of the 4.4% premium collected if the stock had not moved above the strike price.
This is the opposite of what most new traders do. Instead, they are buying the options hoping the stock makes a big move and they make big gains with no guarantee of any premium whatsoever.
Side by side, if the stock moves moderately for 44 days the trader using the Covered Call Strategy still owns the 100 shares and the collected premium while the trader that bought calls or puts has either sold at a loss or held on and lost it all. I like the first scenario and it tends to play out more often than the second.
You can do both but I’m an advocate for selling covered calls first, building up the cash from the premiums collected, and then using that cash for other forms of trading if that is desired. Instead of using your own money, use the premiums collected.
Requirements for Implementation & A Few Rules
As mentioned previously, many traders have taken their initial $500 and blown it up in a bad trade, not because they’re a bad trader, but because they’re still learning and are inexperienced. Instead, the same $500 can be used to buy 100 shares of a stock to then sell calls against.
To sell covered calls you need to own 100 shares of the underlying stock. This allows you to sell the call knowing if the option is exercised, you have the shares to cover the trade. Hence the name, “covered call”. Here are the basic requirements:
Brokerage account with Options Trading made available (usually upon request)
Ownership of 100 shares of the underlying stock you wish to sell calls against
That is all you need to get started. I prefer to use a tax deferred account, like an IRA. That is just my preference as I’m building for retirement and not trying to withdraw for income at this time.
Here’s an example of the Options Strategy Levels offered by Charles Schwab (just one example of many). You can see that the covered call strategy only requires the lowest level of approval, also the lowest risk level.
As with all trading strategies, you will have to fine tune the rules you follow to fit your portfolio. There is never a “one size fits all” approach, but the simplicity of this strategy lends to easier implementation in my opinion.
For guidance, here are the rules I’ve drafted and follow for an effective Covered Call Strategy that works for me.
Identify stocks I want to own (don’t just buy any stock, be interested and expect the stock to grow)
Utilize stocks that you can afford to buy 100 shares of, even if it takes some time to accumulate. If you only have $500 to start, utilize a stock priced at or below $5.
Use charts to identify ranges and buy shares of stock at the low end of the range
Use the identified range to sell call options at the top of the range
Use the average daily price range of the stock to understand how much the stock typically moves, try to ensure your option strike price accounts for this
Sell calls that expire no more than 45 days out and at a strike price near or above the top of the range (I prefer 30 days or less)
Goal is to sell at a strike price that will not be achieved within the timeframe given so the process can be repeated.
Target 3% or more for the premium received, if this is not achievable do not sell the call option
DO NOT adjust strike price and expiration date to achieve the 3% premium
Repeat the process as often as possible, staying true to the criteria for selling calls
These are the fundamental rules to follow that will allow you to collect cash instantly and start building your account. There is nothing more needed than this. However, you can further improve your returns if you spend time identifying stocks with the right characteristics.
Maximize Profits by Leveraging Implied Volatility
The price of an option contract is not an easy calculation, but it is based on all of the familiar inputs outlined so far. There is always an exception though and that is why we should talk a bit about implied volatility.
Implied volatility (IV) is nothing more than a number representing the expected movement in the price of a security (stock). The higher the IV the more volatile the price will be, meaning it will likely move more than when the IV is lower.
The price of an option therefore increases in price as IV increases, all else held constant. This makes sense, right? If the price is expected to move more dramatically there is a greater chance the option strike price is hit and therefore should command a higher premium.
As the option nears expiration, there is less time for the underlying to move and therefore the IV impact reduces (again, all else held constant). This is important as the reduced IV shrinks the price of the call option you sold. This is good because you sold high and can now buy back low.
If you want to buy back the call option and sell a new one at a date further out, you can do so and keep adding cash to your account. If you want to let it expire, keeping 100% of the premium you’ve collected, that is fine too!
Conclusion - It Works Out Even When it Doesn’t
I am clearly a fan of the Covered Call Strategy and I hope now you can see why. The instant gratification that comes with taking in premium while simultaneously owning shares of a stock you are happy to own is far more enjoyable than sweating out the next market open and hoping for a big move.
The way I look at it, there is no way to lose with this strategy. It is a matter of perspective.
If the stock moves up, you’re guaranteed to enjoy the move with the shares you own and can add in the collected premium. If the shares you own have to be sold because they’ve moved beyond the strike price of the option sold, you’ve still sold at a really nice gain in a short amount of time.
If the stock moves sideways, you’ve collected premium that you can do what you’d like with while those that decided to buy calls or puts watch their price decay with time and expire worthless.
If the stock moves down, you’ve collected premium that helps offset those losses. You’ve built in some downside cushion that you can’t get by buying out of the money options. If the stock drops dramatically you will lose money, there is no doubt about that.
This last point underscores the importance of doing the research up front to buy quality stocks that you want to own for the long term. Your portfolio should be comprised of stocks you believe in and for this strategy there is no reason to deviate.
If you plan to own the stock for the long term, even if it drops in the near term, you can continue to sell covered calls against it and effectively offset your losses over time. I think current market conditions are setting up to implement this strategy effectively and consistently over several years.
Stock prices have dropped across the board, presenting buying opportunities for long term investors. There is also a lot of noise to work through including actions from the Fed, associated interest rate moves, inflation, and a potential recession. All of which could keep the stock market trading sideways for a little while. When better to collect premium than in a sideways market?
There is no strategy that guarantees against all losses. There are strategies that allow you to trade with an advantage and I am a firm believer that the Covered Call Strategy can be an effective approach for even the smallest accounts.
This is a great strategy for what may likely be a year or more of a sideways market!