Covered Calls for Beginners

1. Covered Calls: A Low-Risk Strategy for Generating Monthly Income

Covered calls are a safe and straightforward way to generate steady cash flow every month.

Leverage existing investments. Covered calls allow investors to earn additional income from stocks they already own without incurring additional risk. By selling call options on shares you hold, you receive a premium upfront, creating a "synthetic dividend" that can significantly boost your overall returns.

Reduce cost basis. The premium received from writing covered calls effectively lowers your cost basis in the underlying stock. This provides a cushion against potential downside moves and can accelerate your path to profitability. Over time, consistently writing covered calls can substantially reduce your effective purchase price, enhancing long-term returns.

Benefits of covered calls:

• Generate monthly income
• Lower investment cost basis
• Provide downside protection
• Potentially enhance overall returns

2. The Historical Context and Mechanics of Options Trading

Options are an instrument that have been used since ancient times. In fact, their usage predates even the stock market.

Ancient origins. Options trading has roots dating back to ancient Greece, where philosopher Thales used a form of options contracts to profit from olive harvests. This demonstrates the timeless utility of options as a tool for leveraging market insights and managing risk.

Modern evolution. Options evolved through various forms, including tulip bulb contracts in 17th century Holland, before emerging as standardized financial instruments in the modern era. The Chicago Board Options Exchange (CBOE), founded in 1973, brought options trading into the mainstream financial markets.

Key components of options contracts:

• Underlying asset (e.g., stocks)
• Strike price
• Expiration date
• Premium (price paid for the option)

3. Debunking Common Misconceptions About Options

Options are just a tool, not a get-rich-quick scheme.

Risk perception. Many investors perceive options as inherently risky, but this view often stems from misuse rather than the nature of options themselves. When used properly, options can actually reduce portfolio risk and enhance returns.

Versatility. Options provide flexibility in various market conditions. They allow investors to profit from rising, falling, or even sideways markets. This versatility makes options valuable tools for both hedging and income generation when applied with proper knowledge and strategy.

Common misconceptions:

• Options are always high-risk
• Options are too complex for average investors
• Options are only for short-term speculation

4. Selecting the Right Stocks for Covered Call Writing

Ideally, it pays a dividend, so your profits will be boosted by the income you earn from the call premiums.

Stability is key. Look for established companies with steady, predictable growth rather than volatile or speculative stocks. Ideal candidates are often large-cap, dividend-paying companies in mature industries.

Fundamental factors. Consider factors such as low debt-to-equity ratios, consistent profitability, and stable management. Avoid companies with upcoming major events or earnings announcements that could cause significant price swings.

Criteria for selecting covered call stocks:

• Stable, mature companies
• Dividend-paying stocks
• Low debt ratios
• High trading volume (over 1 million shares daily)
• No upcoming major events or earnings announcements

5. Understanding Option Greeks: Delta and Theta

Delta (Δ) is the ratio that measures the change in the price of an asset to the corresponding change in the option connected to the asset.

Delta. This Greek measures the rate of change in an option's price relative to the change in the underlying asset's price. For covered calls, delta helps in selecting appropriate strike prices and assessing the probability of options expiring in-the-money.

Theta. Theta represents time decay, or how much an option's value decreases as it approaches expiration. For covered call writers, theta works in their favor, as the short call position benefits from time decay.

Key points about delta and theta:

• Delta ranges from 0 to 1 for calls (-1 to 0 for puts)
• Delta can be used as a proxy for probability of expiring in-the-money
• Theta accelerates as options approach expiration
• Time decay benefits option sellers (covered call writers)

6. Choosing Optimal Strike Prices and Expiration Dates

For a quick video of how to write covered calls in your brokerage account, we have one on our YouTube channel, which you can find at https://freemanpublications.com/youtube

Strike price selection. Choose strike prices based on your investment goals and market outlook. For income-focused strategies, select strikes with a delta around 0.3 to 0.4, balancing premium income with the likelihood of keeping your shares.

Expiration timing. Aim for options with 30-45 days until expiration to maximize time decay while allowing enough time for the strategy to play out. This timeframe balances premium income with manageable risk.

Guidelines for strike prices and expiration:

• Use delta as a guide (0.3 to 0.4 for balanced income)
• Consider current stock price and potential upside
• Target 30-45 days until expiration
• Avoid earnings announcements and other major events

7. Managing and Exiting Covered Call Positions

Nobody ever went broke taking profits.

Profit-taking strategies. Consider buying back the call option when it has lost a significant portion of its value due to time decay or price movement. This allows you to lock in profits and potentially write a new call for additional income.

Rolling options. If the stock price approaches or exceeds the strike price near expiration, consider rolling the option to a later expiration date or higher strike price. This can help you avoid assignment and continue generating income.

Exit strategies:

• Buy back call when it loses 50-80% of its value
• Roll to a later expiration if stock price approaches strike
• Let option expire worthless if out-of-the-money
• Be prepared to have shares called away if deeply in-the-money

8. The Poor Man's Covered Call: A Capital-Efficient Alternative

The LEAP substitution strategy works best in mature bull markets.

LEAP option basics. Long-term Equity Anticipation Securities (LEAPs) are options with expiration dates more than a year in the future. By purchasing a deep in-the-money LEAP call option instead of 100 shares of stock, you can create a synthetic long stock position for less capital.

Strategy implementation. Buy an in-the-money LEAP call option and simultaneously sell a shorter-term out-of-the-money call option. This creates a position similar to a traditional covered call but requires less upfront capital.

Benefits of poor man's covered call:

• Lower capital requirement
• Potential for higher percentage returns
• Flexibility to adjust long-term position
• Reduced downside risk compared to stock ownership

9. Tax Implications of Covered Call Writing

According to the Options Industry Council, profits from covered calls are treated as capital gains, with a few exceptions.

Short-term vs. long-term gains. Premiums received from writing covered calls are typically treated as short-term capital gains, taxed at your ordinary income rate. However, if the option is exercised, the stock sale may qualify for long-term capital gains treatment if held for over a year.

Qualified covered calls. Writing certain covered calls can affect the holding period of the underlying stock for tax purposes. Ensure your covered calls meet the IRS criteria for "qualified covered calls" to avoid negatively impacting your long-term capital gains status.

Key tax considerations:

• Option premiums are usually short-term capital gains
• Stock sales may qualify for long-term treatment
• Be aware of "qualified covered call" rules
• Consult a tax professional for specific advice

10. Setting Process-Oriented Goals for Trading Success

Instead of creating outcome orientated goals, how about creating process-oriented goals?

Focus on controllable factors. Set goals based on actions you can control, such as following your trading plan, rather than outcomes like specific profit targets. This approach helps maintain consistency and reduces emotional decision-making.

Continuous improvement. Regularly review and analyze your trades to identify areas for improvement. Keep a trading journal to track your progress and learn from both successful and unsuccessful trades.

Examples of process-oriented goals:

• Analyze 5 potential trades daily
• Always use proper position sizing
• Review and journal all trades weekly
• Continue education with paper trading alongside live trades
• Stick to predefined entry and exit rules

Last updated: November 17, 2024