If you want to get started in options, then you have to start somewhere so why not start at the place that the experts consider the most conservative options trade out there, the covered call. It is so considered so conservative that it is often allowed in retirement accounts. It is allowed in mine, and I use it extensively even though I would disagree with its conservative nature, but that is the topic for another post. Instead, I want to explain what the covered call is and explain the process of writing or selling a covered call.
Breaking Down the Terms
First, we need to understand the terminology and that means knowing what a call options is. Simply stated, a call option is a contract that allows the owner of the call the right (but not necessarily the obligation) of buying a particular underlying stock from the call seller at the strike price on or before the expiration date. If none of that made any sense, you may want to check out my two posts “What is an Option?” and “Components of an Options Contract” for a more detailed explanation.
The next term is the word covered. Covered means the same thing when you go out with a buddy and offer to buy his dinner. Saying, “I’ve got it covered” means you have the cash to pay for it. Having the call covered means that you have the stock to live up to the obligation that selling a call places upon you. If I sell a covered call on Intel stock, that means I have enough shares of Intel stock in my brokerage account that moment for fulfilling my obligation if that stock gets called away from me.
The alternative to being covered is being naked. A naked call is one that is sold without owning the stock or enough of the stock to meet the call obligation. If the call gets exercised, then the seller of a naked call would have to go into the open stock market and purchase the shares for delivery to the owner/purchaser of the call.
Writing a Covered Call
So if we are writing a covered call, we are selling call options against stock that we already own in our brokerage account. This is why it is considered a conservative investment strategy. The stock is already owned so the risk of having to go into the open market and buying the stock (as would occur with a naked call) no longer exists.
The process of writing a covered call is simple. The first step is to own an optionable stock. Not all stocks will allow options contracts to be written against them, but the stocks of the larger companies will. This is determined by the Chicago Board of Options Exchange. Assuming you own such a stock, then for each 100 shares, 1 option contract can be written. This is a very important point and can get a little confusing at first. Again, a round lot of stock is 100 shares and each call option is for 100 shares of a particular stock.
Another term you will run across is open interest. A contract doesn’t exist until someone actually opens one and offers it for sale in the market. You can see the amount of open interest along with the pricing quotes in the option chain which is a list of strike prices, expiration dates, and bid/ask prices for a particular option series in a given stock. Typically, the most open interest occurs around the current market price of the stock.
In order to sell (or write) a covered call, one would go to the proper options trading page in one’s brokerage account and enter a “sell to open” order for a particular call option which would specify the number of contracts, the underlying security, expiration date, and strike price. The next step is to enter a market order, meaning the option would trade at the market price (not wise) or a limit order, meaning that you set the price you are willing to accept. Typically there is also a criterion for the order such as “good til canceled” or “day order”. And that’s it, you have written a covered call.
An Example is in Order
Of course, it is always easiest to learn by example so let’s look at one together and explain as we go.
Investor Warren has a portfolio full of stock and would like to begin selling covered calls against that stock. He owns:
- 2,000 shares of Coca-Cola (KO) and
- 1,000 shares of Bank of America (BAC)
He decides to write calls against half of his positions in order to gain a little more income for the portfolio. Starting with KO, he sees that the stock is trading at $69.57 per share. He would be willing to part with the stock in the next 3-4 months for $75 per share so he looks at the January 2012 call chain and finds that the bid is $1.14 per share for the $75 strike price. He goes into his brokerage account and enters a limit order to sell 10 call contracts for $1.15 for the day only. Within an hour, the stock has traded up to $69.80 and his limit order is filled.
Now what has he done? He has agreed to sell another investor 1,000 shares (remember each contract is for 100 shares) of Coca-Cola stock for $75 per share any time between now and the third Saturday of January 2012. If KO is at $100 on January 21st, then the call buyer made quite a profit. If KO is still at $70, then Warren will keep his stock and the option premium that he received. He also would have realized an additional 1.5% yield on his stock.
Doing the same with BAC, he finds that he can sell call options with the $7.50 strike price expiring on January 21, 2012 expiration for $0.63 and is happy with that so enters a limit order to sell 5 call contracts. These sell and Warren is happy when BAC is trading at $8 on that day because he made the 63 cents per share option premium and an additional $1.02 in capital gains from the current $6.48 stock price for a total profit of $1.65 on his $6.48 investment or a gain of just over 25% in less than 4 months.
I hope that you better understand the process of writing a covered call and have a better sense regarding what is involved. Next week I will offer some tips for being more successful writing covered calls. In other words, I will share what I have learned from all my mistakes.
Readers: Did you understand what I wrote? Have you written any covered calls? Do you think this might be something you would like to try? Feel free to comment below.
There has been a lot of interest from readers regarding learning about options and getting started in options trading. But first, I would like to offer the requisite disclaimers. I am not a professional options trader, but am simply an everyday individual who has been trading and using options for his own accounts since 1999. Through these 13 years of experience, I would like to think that I have learned a thing or two and would like to share these things with you so that you don’t make some of the same mistakes that I did.
It Starts with Education
Learning about options is much like learning an entirely new language. It is not that it is any more difficult than learning any other new skill like welding or accounting or Spanish. It is simply intimidating for many people because of the terminology and the fact that money is involved.
So the first thing that I would recommend is getting a solid foundation by learning about the terminology involved and reading a book or two on the subject. I counted my books on options trading yesterday and found 11 on my bookshelf solely devoted to the topic. I have many others on stock investing and real estate as well.
Of those that I have, there are two that I would recommend for beginners:
“Getting Started in Options” by Michael C. Thomsett which is available at Amazon for $13.57 and “Stocks for Options Trading: Low-Risk, Low-Stress Strategies for Selling Stock Options-Profitably” by Harvey Friedentag which is a lot more expensive, but worth it. This book is from 1999, and I noticed that he has a new book that came out in 2009 which I haven’t read.
You could search for these books and others through my Amazon link at the end of this article. I am an affiliate so would pick up a small commission.
Of course, there are plenty of free resources on the web to learn about the terminology. I am working on one such resource over at OptionsDudeAtoZ. You can also follow some of my trading at OptionsDude.com. There is also a forum over there where you could post questions. I would be happy to answer them and get into much greater detail.
Consider Paper Trading
It is always recommended that investors learning something new start with paper trading. While I have done a little, I must confess that paper trading just didn’t mesh with my personality. You have to understand that there is a big difference between simulated trading and trading when real money is on the line. A HUGE difference! Everything you thought you knew flies out the window once emotions become involved, and I guarantee that they will.
There is nothing wrong with doing a little paper trading initially to make sure you understand what you are doing and the impact that certain market movements will have on your positions. Just understand that it is different from actual trading.
Start With Level 1
If you want to trade options, you have to be approved by your brokerage. Brokerages have different levels of approval depending upon your amount of capital and experience. These levels will range from level 1 up to level 4 or 5 depending upon the brokerage. At E*Trade for example, level 1 only includes covered calls. Covered calls are considered the most conservative options trade, but I believe that the safety of covered calls could be a total myth. Be that as it may, it is still a good place to begin one’s understanding of call options.
For my next post, I would like to begin discussing covered calls and what I would do now following years of experience. I would like you to avoid many of the mistakes that I made. I do learn from my mistakes and have found experience to be a good and thorough teacher.
I recently wrote about how I will be undergoing a change in my work structure and will be getting a match with my 401(k). A lot of people refer to this as “free money” although you can easily make the argument that it truly is part of my compensation and has to be figured into the overall equation.
But just this weekend, I received some free money that was truly free and came from a source that I never would have suspected. Interestingly enough, this source involved my current 401(k).
Selling Covered Calls
Some of you know that I have been trading options for over a decade, not professionally but for my own retirement accounts. I am able to do this since I have a self-directed account with Fidelity which allows me to trade options. You can follow some of my trading in Silver Wheaton stock at OptionsDude.com.
Well it turns out that with this most recent options expiration day, I had sold some covered calls on SLW with a strike price of $40 per share. I figured that since SLW stock had closed well below that at $39.54, those calls would have expired worthless. Imagine my surprise when I logged on this weekend and found that they had been exercised! Someone had purchased Silver Wheaton from me at $40 per share when they could have purchased it in the open market for less.
Not Free Money Yet
But it really wasn’t going to be free money yet until I could buy back my stock at a price less than $40 per share. I figured it would be possible on Monday but not guaranteed. Typically the daily range of stock will encompass the previous day’s closing price so I felt that the odds of me getting back into my original position at $39.50 were pretty good unless there was a major gap upwards.
So Monday morning, I watched the action of the gold and silver prices as well as the futures for the stock market and the before market trading of SLW. I entered a limit order at $39.50 and ignored the market while at work. I was able to check periodically throughout the day and found that indeed my limit order was filled meaning that I had received a gift of 50 cents per share. Yippee! Free money!
But what would have happened if my limit order was never hit? The number of shares involved was only 22% of my total. I would have waited for SLW to decline in price since it is very likely that it would have sometime in the near future. I was happy with a 50 cent per share discount. I was also happy if the stock kept going up since I would benefit from the increase.
I was in a position to benefit no matter what the stock did. An increase meant additional profit on my existing shares. A decrease meant a discount on the purchase price to re-establish my original stock position. There was no reason to chase the stock.
Now I was in a different position with my ONXX trade. I will be updating that and how I handled the situation in the next week or so at the Options Dude blog. It was a totally different set of circumstances so I managed my trades quite differently.
Getting Started in Options Trading
I have been asked about options trading and will probably write my next post on the topic. It may end up being a long one or need to be split in two. I am also working on a fairly comprehensive website/blog that will cover the topic and would like to get an e-book together. But it seems like it may be some time before I can get that done since I am incredibly busy. I may have some more time during the winter months, but we all know how that typically goes. I wish I had 36 hours per day.
Readers: Have you ever gotten some money that was quite a surprise? Are you interested in learning more about options trading? Any other comments or questions? Anyone interested in guest posting so I can have more time at OptionsDudeAtoZ. Feel free to comment and thanks for reading.