Covered Options Explained – Covered Calls and Puts

Covered Calls/Puts are one of the most common and good option strategies, especially among beginner option traders. It is one of the best ways of getting into options when you come from stock trading. It combines stock and option trading. This is neither an option only or a stock only strategy. This strategy is also a good introduction and first step into high probability option trading. The idea behind covered calls/puts is to cut the upside potential for an increase in likelihood of success. With this strategy, you can slowly finance the bought shares with the money from the sold options. I will try to break down the covered call/put strategy in the following article.

Covered Calls Explained

covered call payoff diagram

Market Assumption:

When writing covered calls on your existing stock positions, you still can have more or less the same market assumption as before. Without a covered call you hope that the stock price will go up as much as possible. But with a covered call, you actually don’t really care if the price goes up or just stays the same. As long as the price does not go down, you can make money. So your ideal market assumption should be slightly bullish to neutral. If you are very bullish and expect the underlying to skyrocket within the next few days, a covered call is probably a bad idea, because this would cut all your gains after a certain price point.

Setup:

  • Sell 1 Call (for every 100 shares of stock)

The sold option should result in a credit (get paid to open).

Profit and Loss:

When you look at the payoff diagram of the selling covered calls strategy, you can see that it looks somewhat similar to the payoff diagram of a stock and a credit spread. The downside is exactly the same as the one of a normal stock and the upside is just like one of a credit spread. So if the price of the underlying moves down, you lose money linear. Your max profit will occur when the underlying’s price moves up and beyond the strike of the sold option. The loss is unlimited, so this strategy is a defined profit and undefined risk strategy. This may seem like a downgrade from a normal stock without a covered call, but this is not the case. For every sold option, you take in some money. This means that your break even point and your entire stock payoff will move a little to the left. This gives the stock’s price more room to move in. If the stock price, would not move at all for a few years and you constantly sell covered calls on it, you will still make money. This would not be the case, if you hadn’t written covered calls. Basically you can slowly finance your stock position with covered  calls.

Maximum Profit: Premium received + Strike Price – Trading Price of Underlying when bought – Commissions

Ex. (ABC was trading at 100 at time of long entry, Call sold at 105 Strike) => 20$ (Premium) + 105 (Strike) – 100 (Underlying Trading Price at Entry) – 3$ (Commissions) = 22$ (*100, because you have to own and the option normally controls 100 shares) = 2200$ (max profit)

Maximum Loss: N/A (unlimited)

Implied Volatility and Time Decay:

Time Decay or the option Greek Theta works in favor of a covered call. This means, the more time goes by, the more profitable this strategy will be. This is the case due to the loss of extrinsic in the sold options. The amount of lost value increases, the closer you get to expiration.

A covered call profits from a drop in implied volatility (IV) and should therefore ideally be used in times of high implied volatility (IV rank over 50). Doing this will increase the premium taken in and can eventually increase your chances of winning. Nevertheless, it is not necessary to trade covered calls in a high IV environment.

 


Covered Puts Explained

Covered Puts are more or less the same as covered calls, just for shorted stock and with a put. So this strategy only works if you have a short position in some kind of underlying.

covered put payoff diagram

Market Assumption:

Before writing a covered put you probably already shorted some kind of asset, so your directional assumption on that asset clearly should have been bearish (you hope the price falls). This should stay more or less the same. The only difference being that you don’t hope for a huge down move with a covered put. With a covered put you should be slightly bearish to neutral. Just like it is with covered calls: if you are very directional, covered puts/(calls) are not for you.

Setup:

  • Sell 1 Put (for every 100 shares of stock)

The sold option should result in a credit (get paid to open).

Profit and Loss:

The covered puts strategy is a defined profit and undefined risk profit strategy. The payoff to the upside stays the same as it would have been for a normal short stock. But profit potential to the downside will get cut off. So if the price of the underlying moves to a certain point, you won’t make any more money. This may seem like a downgrade from a normal stock without a covered put, but this is not the case. For every sold option, you take in some money. This means that your break even point and your entire stock payoff will move a little to the right. This gives the stock’s price more room to move in. If the stock price, would not move at all for a few years and you constantly sell covered puts on it, you will still make money. This would not be the case, if you hadn’t written covered puts. So with covered puts, you can slowly finance your stock position. Max profit will be achieved if the underlying’s price moves down to or further than the strike of the sold option.

Maximum Profit: Trading Price of Underlying when sold/shorted – Strike Price + Premium received – Commissions

Ex. (ABC was trading at 100 at time of short entry, Put sold at 95 Strike) => 100 (Underlying Trading Price at Entry) – 95 (Strike) + 20$ (Premium) – 3$ (Commissions) = 22$ (*100, because you have to own and the option normally controls 100 shares) = 2200$ (max profit)

Maximum Loss: N/A (unlimited)

Implied Volatility and Time Decay:

Just as a covered call, a covered put also profits from time decay. The more time goes by, the more the sold options will lose in value, thus creating a profit for a covered put writer.

The covered put strategy also profits from a drop in implied volatility (IV) and should therefore also ideally be traded in a high IV environment (IV rank over 50). But again, this is not necessary.


Trader’s Note:

Covered Calls and Puts are great and very profitable, market beating strategies. I think this strategy is a great and common way to transition from stock to option trading. But as clearly seen, this strategy does still require the belonging of stock (and quite a lot of it as well). Options normally control 100 shares of stock, so just to write one covered put/call, you have to be long/short 100 shares of an underlying. This can be very capital extensive, especially for beginners. But in my opinion one should never buy any shares, just to do covered calls/puts on them. This would be a very stupid move. Covered puts/calls should only be done if you already (plan on) have shares in a certain stock. It is just a good way of capping the profit potential for some high probability premium.

Additionally, I think trading covered calls/puts is not only a good introduction to option trading, but especially to (high probability) option selling, which is great. The idea behind high probability option selling is to remove some upside potential to increase the chances of winning.

If you want to learn a similar strategy that does not require you to own any shares, you could check out my strategy breakdown of credit spreads here. Credit spreads work almost the same, just without the stock.

Nevertheless, I really believe that covered calls/puts are a very great strategy. Prices do very rarely move big amounts at a time and it is even harder to predict the very few stocks that actually do that. This is what covered options and high probability option selling in general takes advantage of. To learn more about options and my profitable high probability option selling strategy, check out my education section here!

4 Replies to “Covered Options Explained – Covered Calls and Puts”

  1. I liked reading about the covered calls as a strategy for income. I have actually doe this and recommend it for investors who have larger accounts and are holding stock in their portfolios. It is a good introduction to high probability option trading as the object is for the options to expire worthless after seolloing them. The examples were a olittoe hard to follow if someone is not ready famiolar with trading in general and options in particular. Over all a good explanation of what a covered call trade is. I was looking around your site further and really like the way you have the menu arranged with multiple dropdown I willo have to see if I cn impolient that in mine, I really like using the weeklies for this as well as the other income trades as they are faster to compete and give more opportunities for profit and quicker recovery of the cost of the original stock – nice to get it down to zero cost to own a good stock.
    I will be going back over the rest of your site as time allows. Nicely done thanks.
    Louis

    1. Hey Louis,

      Thanks so much for the positive feedback. It seems like you really have understood covered calls!

  2. Louis – here is a different kind if question – not strategy, but just operational.

    I bought some AAPL and then sold some covered calls. I saw the amount of “profit” from the covered call I sold show up in my portfolio, but it was also changing as the stock price changed. Furthermore, I never actually saw the funds I got from selling the covered call go into my acct.

    Do you have to wait for the options to expire before you see any money go into your account?

    1. While your position is still open, your profits will only be paper profits. To turn your paper profits into real profits/money, you have to close the position. You can either let the calls expire worthless or buy them back to close the position. When buying back the calls, you should ideally buy them back for less than you initially sold them for. Otherwise, you won’t make a profit on those calls. However, depending on how AAPL moved, you might still have a profit on the overall position.

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