How to Trade Covered Calls With Stocks You Already Own
The one strategy most investors already know when it comes to options trading is the covered call. It’s also one of the first strategies that most investors try to learn when they enter the world of options. But do you know how to trade covered calls on stocks you already own?
That comes down to the structure of covered calls — in other words, what does covered mean in this sense? When we go into the open market and sell a call option short, that’s a naked short call strategy. It’s not exactly the most highly recommended move for traders. However, the trade becomes a covered call when we own stock against that call.
What does that mean? When we are long shares of ABC and sell a call against it, that’s a covered call. It does not work if we own shares of XYZ and sell a short call on ABC. There’s another caveat. For it to be a covered call, we need to own 100 shares of the underlying security.
For instance, if we own 100 shares of ABC and sell 1 call against the position, that fits the description. The same is true if we own 1,000 shares of ABC and sell 10 calls against the position. This is because each call option is a contract representing 100 shares. By selling that call, we’re entering an agreement to deliver 100 shares of the underlying stock at a predetermined price (the strike price) at a predetermined time (the expiration date).
It’s also acceptable to sell less covered calls than what we own. Say an investor owns 1,000 shares of ABC. If they’d rather, they might consider selling covered calls on only half of their position.
Why do this? Perhaps the investor thinks they might get a better price in a few days, so he wants to be able to sell the other five calls later but still lock in today’s prices. Maybe the investor doesn’t want to part ways with all of their position, but would be comfortable with half their holdings being called away, provided the stock closes above the strike price on expiration day.
Trading Covered Calls to Protect Profit
It all really comes down to comfort — and risk/reward. For being so basic, the covered call is actually quite versatile. Say there’s a large rally in a stock that we own 200 shares of. Shares of MNO have gone from $50 to $65 in six weeks and is looking tired.
We could sell 1 $65 call for $2.00 expiring in two weeks. This lets us stay long and we are comfortable if the stock gets called away at $65. For our willingness to sell the stock, we are collecting $200 in credit. Assuming we hold until expiration and are fine with either outcome, that essentially allows us to cash out at $67 if MNO closes at or above $65.
If the stock pulls back, we are protected down to $63 on 100 shares. By only selling 1 option, we have flexibility. For instance, if the stock continues higher, perhaps we consider selling the $70 call against our last chunk of 100 shares.
In the case above, we sold a covered call at-the-money. Most investors who sell covered calls against stocks they already own will often do so out-the-money. In the case above, that may have meant selling 2 $70 calls against our 200 shares when shares are at $65.
Again, it comes down to risk/reward and comfort. Are you comfortable if shares get called away at $X + net credit or are you more comfortable at $Y + net credit?
That’s something that investors will have to figure out on their own, as it will be different for each investor. When selling covered calls on stocks you already own, also consider the various potential tax implications if your stocks do get called away.
Trading Covered Calls for Income
In the example above, the investor looked for a way to take partial profit without selling any stock. In a way, they said, “I am fine if my stock gets called away here, to book solid gains. If it pulls back a bit, I am happy to keep holding and collect my net credit.”
But there are other ways to use covered calls too, one of which is income. Say we have a stock that pays a decent dividend yield of 2%. However, the stock is a slow mover and often times gets caught up in a trading range for several months at a time.
One way we could enhance those gains and specifically enhance the income we receive is by selling covered calls. Say shares of EFG trade at $53 and pay out a quarterly dividend of 33 cents per share and we own 500 shares.
Every quarter we collect our dividend payout of $165. We’re pretty happy with modest dividend, but there’s a way to greatly enhance that yield. We look for out-the-money calls on EFG to sell, hoping to collect about 20 cents per contract. In all, we’re looking to go out about three to four weeks and collect $100 to $125 in net credit by selling covered calls. We can even skip one month per quarter to account for earnings (because we like our stock holding in EFG and don’t want it to get called away, particularly on a big rally). Even if we do this twice per quarter, we’ll still collect $200 to $250 in net credit during the quarter.
That’s more than our entire dividend payout and drastically improves our dividend yield, synthetically speaking. Of course, these funds come with a caveat, which is that we may have our stock called away should it rally.
Using Covered Calls for Protection
We kind of touched on this before, but one way we can use covered calls is for protection. The covered call strategy works great for income or collecting some credit after a big run in stocks we already own.
Using covered calls doesn’t provide the most protection, but it does work to some degree. Others may find the collar (selling a call and buying a put) or a protective put more attractive and in some cases, they are more appropriate.
But because we are collecting a credit from our trade, it does help protect against a slight decline. Say we own XYZ, which is trading at $100 per share. The top of its recent range is between $90 and $100. As such, we sell 1 $100 call expiring in 25 days, collecting $3.00 for the trade. While not a ton of protection (particularly if XYZ falls back down to $90), we are protected on a fall to $97.
Again, it’s not the most protective strategy, but on top of reducing some risk and collecting a nice premium, we do get some protection should shares pullback. Ultimately, those are three nice benefits — particularly for stocks that we already own.