How I do it

I maintain a portfolio of core stocks, each with at least 100 shares. Instead of waiting for the stock price to increase, selling a covered call on those positions allows me to earn an additional 1.5%-4% each month, depending on how aggressive I want to be. 
If I’m ready to part ways with a stock, I tend to be more aggressive. It’s crucial to remember that if a stock reaches your strike price, you are obligated to sell it at that price. 

Example

 I own 100 shares of Uber with an average price of $40 per share. As of this writing in October 2023, Uber stock is at $41 per share. I can sell a covered call on Uber expiring in 30 days (about 4 and a half weeks) for November 24th at a strike price of $45 per share. Since I usually aim for a 1.5% return on covered call trades, I would be collecting $89. 
This is a trade I could execute right at market open before starting my workday, and it would take me less than 5 minutes. 

How I sell covered calls while working full time 

The reason I can sell covered calls while working full time is that I primarily engage in selling monthly covered calls. This means there’s minimal work once the trade is executed, except for managing the position if the trade goes against me. 

Leveraging returns 

I leverage returns from successful covered call trades in two ways: 

Buying more of the stocks I already own: If I believe the stocks I own are still undervalued, I slowly dollar-cost average into them to fully build out my position.
 

Buying a new stock: If there’s a stock I like but don’t yet own, I gradually build out my position. My regular income, along with the income generated from selling covered calls, helps me achieve this in a much shorter timeframe. 

I always believe that great companies don’t stay at low prices for long. I’m delighted if I can pick up additional shares because of the income generated from selling covered calls. Depending on the stocks you’re buying, consider their potential value in 5-10 years. 

Three rules I follow to stay grounded

        Always set price target alerts: 

• Acknowledge that you won’t be able to monitor your stocks at all hours of the day. 
• Price alerts will notify you when it’s time to log in and manage your position.
  

  Always have a profit target: 

• A good rule of thumb for me, is to close a trade when it’s 70% profitable. 
• For instance, using the example of the Uber trade discussed earlier, closing the trade at a 70% profit would result in earning about $62 from the initial $89 investment.
  
   

  Stay consistent with your trading plan:

• Emotions in trading can lead to losses and inconsistent results. 
• Deviating from established rules, such as the 70% profit target, in pursuit of more earnings may result in staying in a trade too long and potentially turning it into a losing one. 

While there is much more to selling a covered call, I am convinced that anyone can successfully sell covered calls while working full time. For additional information, check out this post about covered calls for more in-depth insights. 

The post How I Sell Covered Calls while Working Full Time appeared first on Financial Browsing.

 In today’s dynamic financial landscape, investors are constantly seeking innovative strategies to generate income from their investment portfolios. One such strategy that has gained popularity is the use of covered calls. Covered calls offer a unique way to earn consistent income by leveraging your existing stock holdings. This blog post aims to provide a comprehensive guide to using covered calls to generate income, offering insights into the concept, benefits, risks, and practical implementation. 

Understanding Covered Calls 

The beautiful thing about covered calls is that they are an extension of your investment journey and usually build on top of any pre-existing knowledge you already have about the stock market. What I mean by that is, someone is more likely to find out about covered calls if they are already invested in the stock market rather than getting involved in stocks solely because of covered calls. 

Mastering the use of covered calls to generate income, although not easy, is very rewarding and potentially life-changing. It will display your evolution as an investor, which will boost your overall portfolio returns. 

Definition and Basics 

The building block of covered call writing is stock ownership. You must own at least 100 shares of a particular company, once you do, selling a call option means you are willing to sell your shares at a predetermined price no matter if the stock price goes up or goes down. 

Stock Ownership

If you don’t currently own 100 shares of a company, this is where you want to start. Building your portfolio is a slow process, especially if you are on a fixed income. But with some long-term planning, consider that you will be able to make 2%-4% from your portfolio. The bigger the portfolio, the bigger the returns you will see.
Call Options 

A covered call is you selling a call option to a call buyer on the other side of the option chain. What this option buyer is hoping for is an increase in the stock price, which would result in the contract they bought being worth more than their purchase price.

Premiums

Your objective from this transaction is for the stock price to stay below your strike because that will mean that your trade was successful, and you got to keep all the premium you were paid for selling the call. For example, if you sell a weekly call option on PayPal at the $62 strike price when the stock is currently trading at $59 per share, you would collect and keep your premium if the stock price stays below $62 at the end of the week.
 

How Covered Calls Work

Using covered calls to generate income is a great way to increase your portfolio returns in any market environment. This strategy allows you to make your stocks work for you. Many people simply buy stocks and hope that they go up eventually; expanding your knowledge base to include covered calls will increase your returns by 2%-4% a month.
 
 

Benefits of Covered Calls

Covered calls and trading options in general are tools available to every investor that allow for income generation and hedging strategies. Investors who are not aware of these strategies usually watch their returns disappear in a market downturn or get forced to panic sell and end up selling too early.

Income Generation: Earn Premiums 

In my opinion, once you’ve been able to string together 4-6 weeks of successful trades and premiums collected, this is how you will know you have reached the ability to consistently start using covered calls to generate income. Once you’ve reached that point of predictability, you can start to expand into different strategies with the income, start paying yourself from the income, or start buying more stocks you value.
 

Risk Mitigation: Downside Protection 

Covered calls provide downside protection through the premium you successfully collect after every trade, the way this works is think of the premium you collect as lowering your cost basis. For example, if you bought 100 shares of Palantir stock at $14 which means you paid $1400, if you sold a covered call and collected a premium for the month of $56 which is about 4% your cost basis went from $1400 paid to $1344 or $ $13.44 per share. The numbers start looking even better the more often you do this. 

Capital Appreciation Potential  

The benefit of using covered calls to generate income is that you are compounding growth in your portfolio with every premium collected. The great thing about this strategy is that you can keep compounding this growth in your portfolio regardless of whether or not your stock returns are outperforming the market. 

Risks and Considerations 

With every options strategy there are risk and reward outcomes you must consider. This great thing about covered calls is that if the strategy is executed properly, you are not introducing any new risk to your portfolio beyond the risk you would’ve had simply buying and holding the stock.  

Limited Upside Potential 

This point is an important one, you have to be disciplined when trading covered calls, otherwise you’ll find yourself second guessing yourself every time the stock price goes up.  

Opportunity Cost

Conviction in the stocks you build your portfolio around is very important. Stocks are guaranteed to go up and down in the short term, but generally go up over the long term. When the price of your stocks starts to drop, you want to make sure that the stocks you own are worth owning; otherwise, you will be forced to hold on to a losing position for a long period of time and miss out on gains you could’ve had by investing in better stocks. 
 

 Even worse, if you find yourself in a panic you might sell a winner at the absolute worst time. Think about those early sellers of Tesla or Nvidia stock. 

Market Volatility

When the market is very volatile, you will notice severe price movements in your stock positions. These volatile moments could be opportunities to take advantage of the market and make great gains, or the time to sit on the sidelines and let things cool down. The worst position to be caught in is when a covered call goes against you on a stock you are not ready to get rid of.
 

Selecting Stocks and Options

Choosing your stock and options strikes are going to be a big determining factor of your success as a trader.  
 

Choosing the Right Stocks

I might’ve mentioned stock selection a couple of times already in this post, but it really is that important. Everyone finds out what their risk tolerance is once their portfolio value starts to decline, and you will discover how high your conviction is in your individual stocks when their value starts to decline by 30% or more. This is why choosing the right stock is important; you want to be so confident in your picks that a price decline just looks like a buying opportunity.
 

Evaluating Option Contracts

The evaluation process of any option contract should be focused on a couple of things. You want to make sure that the option has a lot of open interest, which is going to be great for liquidity when you need to exit the trade. Plus, you will not lose money on the bid and ask spread on your entry and your exit. 
 

Setting Strike Prices and Expiration Dates

Choosing your strike price should be based on what you’re hoping to achieve on your monthly returns. If you are hoping for a 2% return in a month, you would choose the strike price that corresponds to the premium you’d like to collect. Whether your trades are weekly or monthly depends on your schedule and how active of a trader you’d like to be. Monthly trades require less position management and are usually ideal for anyone who trades while working a full-time job. 
 

Implementing Covered Calls  

Once you are ready to start using covered calls to generate income, make sure to always start your trades with a lot of thought and consideration for what your potential losses might be. 

What I mean by that is, even when you are up on a position and your covered call gets in the money, unless you are prepared to lose your shares, that would be a situation where you want to buy to close that trade if you are still seeing a lot of upside in your stock position. 

Step-by-Step Guide 

This example below is a quick example of what a trade looks like on my brokerage account. Everyone has their brokerage of choice; I like Robinhood because they really have a user-friendly interface. 

1. Identify the stock you want to own
   As of this writing I am long a lot of fintech stocks, Paypal is stock I currently own because it’s been really beat down over the last couple years and the risk reward on the investment seems worth it, the financials for the company also looks pretty good.
2.  Determine the length (weekly, monthly) of your trades
   With my full-time work schedule I am currently using covered calls to generate income monthly, I find it’s a lot easier to manage monthly trades.

1. Calculate your returns
   This monthly return on PayPal is about a 2% return
   
   ,

• Calculating Potential Returns
  The more and more you trade for yourself you will figure out what returns you’d like to receive on a weekly or monthly basis. From what I’ve seen from experience, my consistent returns come when I target returns of 1%-4% per month. 

• Real-world Example
  the example below shows what a covered call trade on Palantir stock would look like. The time frame on this trade is 30-day trade. If the trade is successful, we earn 4% or $57. 

Advanced Strategies and Techniques

As you gain more experience through your trades and experience the inconsistencies of profitable and losing trades, you will realize that the covered call strategy and the likelihood of success mostly has to do with position management.
 

Rolling Covered Calls 

There are typically two main reasons to roll your covered call positions: first, to lock in profits early if the expiration date is still far away; second, to manage your risk when your call position is in the money. When your call is in the money, the main goal now becomes to minimize your losses. 

A great way to do this is by rolling your position which starts by closing your initial trade while simultaneously opening a new trade on the same stock for a later timeframe at a higher strike price to increase the chance of profit and hopefully breakeven on the overall trade. 

Collar Strategy: Adding Protection 

Adding protection, also known as hedging, is a tough concept to master as an option trader because it requires you to be both bullish and bearish. The way to initiate a collar strategy is by opening a covered position on one of your stocks and buying a put option on the same stock. 

What this trade does is protect your stock from a big price drop with the put you purchased. For example, if your cost basis on PayPal stock is $63, you might want to give yourself a 10% downside protection by buying a put option at the $57 strike price. 

. 

 You could be bullish on a stock position because it is currently undervalued, but you might start noticing that the market is in a short-term downtrend, purchasing a put would be the way to protect and maybe even profit from a down market. 

Tax Implications 

As an active option trader, you will find yourself paying short-term capital gains tax on your trades. Paying taxes is a great sign of success because it means that you are becoming a profitable trader. It’s never fun paying taxes, but that is just a part of the trade. If you are trading for retirement and are not in need of the money right away, a great strategy you can implement is trading options in a tax-advantaged retirement account like an IRA or a Roth IRA. This is a great way to trade without worrying about paying taxes on your profits in the short term. 

Monitoring and Managing Your Positions 

Learning to manage your trades will help you go a long way in becoming a successful options trader. When you sell options like a covered call, your position will go from being profitable to unprofitable as quickly as the stock prices movements. This is the perfect reason to have a strategy based on position management and rules in place on when to take profits. This will help you keep your emotions in check and simply follow your trading plan. 

Regular Portfolio Assessment 

Not being too overextended and having a condensed watchlist is one of the best ways to stay on top of opportunities when they present themselves. For example, if you initially opened a position on PayPal, and the stock has been trading sideways for a month or so, and your watchlist indicates that Uber stock has taken quite a dip, if you now feel that Uber is a better position to own because of the price drop, don’t be afraid to reassess your portfolio for the better stock. 

When to Roll, Adjust, or Close Positions 

We covered rolling as a great risk management strategy, but rolling can also be used when your trade is successful. As part of your trading plan, your success rate as an option trader will increase significantly by having rules in place on when to take profit. 

For example, when I trade, if my positions are within the 50%-70% range, I start considering taking profits. This rule is important because in a volatile market, your positions will flip between being profitable and unprofitable very quickly. 

Common Mistakes to Avoid 

As an options trader, no matter how experienced you are, you will make mistakes here and there. The key to your continued success will be to learn from those mistakes to become a better trader. 

The stock market is very unpredictable. The best you can do is make trades that have a high probability of success. 

Overlooking Market Research 

Staying connected to what is going on in the financial markets and global politics is an essential part of your success. For example, not knowing that inflation is rising and that the Federal Reserve is hiking interest rates to actively reduce inflation would limit your chances of success since you don’t have the full picture. 

Ignoring Diversification 

Keeping yourself well diversified is key to surviving as an options trader. It’s really tempting to want to put all your funds into one trade when the returns look attractive enough, but taking the less risky approach will make it more likely that your account returns won’t be destroyed by one bad trade. 

Failing to Plan for All Scenarios

Black Swan-type events are the unpredictable scenarios you want to plan for as an option trader. Consider what your portfolio would look like if you were too concentrated during the scare of March 2020 when the whole stock market crashed to an extreme level due to a lot of fear and uncertainty. Granted, if you were selling covered calls, you would’ve made money, but having a great risk-defined strategy is always best. 
 

 The goal is to make the returns, but also not give them back with one bad trade. 

Covered calls can be a powerful tool in your toolkit, providing an avenue to generate regular income while maintaining a certain level of risk control. Consider that most people, if they ever get started investing at all, simply just buy and hold stocks and hope for the best. I’ve learned the hard way that the market is very unpredictable and using covered calls to generate income is a great way to benefit from down markets and allow your portfolio to grow in any environment. 

With any investment strategy, it’s important to understand the mechanics, benefits, and risks before jumping in. I hope by following some of the details outlined in this post, as investors you can harness the potential of covered calls to enhance your portfolio’s income stream and potentially achieve all your financial goals. Remember, becoming successful at trading requires ongoing education, careful planning, and adapting to the ever-changing market conditions. 

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Understanding Cash-Secured Puts

A cash-secured put is an options trading strategy that involves selling a put option, this means you have the obligation to purchase 100 shares of the stock the put was sold on, you receive a premium for taking on that risk, while simultaneously setting aside enough cash to cover the potential purchase of the underlying asset if the option reaches the strike price and is exercised. 

 Let’s break down the key components: 

Identifying a stock

Stock selection is one of the most important parts of this strategy, you might decide that you want to own shares of a specific company for a multitude of reasons centered around the future value of the company. As part of your trading plan, form a strategy around how long you’d like to hold the stock for if you get assigned those shares. The less capital you have the riskier the stocks you initially pick will be. For example, if you only have $500 you will be limited to stocks that are under $5 a share since selling a put option consists of buying 100 shares of a given stock upon assignment. 

Securing cash

Set aside enough cash in your account to cover the potential purchase of stock.
The reason cash secured puts are an ideal strategy to undertake is because anyone can get started with this strategy whether they have $500 or $5000.  For every successful trade made you get to keep the premium you received, typically around 2%-4% per month. With time and the right approach your returns will slowly compound, and you will see your account size grow. Adding a little fuel to the fire with a consistent injection of cash into your account will only increase your returns over time. 

Selling a put option: Selecting a strike price 

 When you are in the process of deciding which stock to open a position on, one of the things that will determine how successful you are as an option seller is how you select your strike price on trades, this means the cost per share at which you are willing to own the shares. 

 Typically, when you select a strike price, you’ll want your entry point to be below the current share price of the stock to give you a margin of safety, but sometimes there will be some exceptions to that rule depending on how aggressive you’d like to be. For example, a stock like PayPal which as of July 2023, is down 80% from its highs might warrant a more aggressive approach than a stock like Tesla that is up almost 50% in a few weeks as of the writing of this article. 

When you see opportunities in the market, your strategy should be flexible enough to take advantage of them. When you are selling puts you must assume you will eventually get assigned, so it makes more sense to get assigned shares of the stock that is down 80%. One of the main goals of using this strategy is to gain a better entry price and purchase undervalued stocks. 

The two best put selling strategies

The biggest determining factor of your success as a put seller is understanding what your approach is to any given trade. Your approach to one trade might be to gain a better entry on the stock you are trading, or your approach could be to simply generate income with no intention of getting assigned. 

Let’s look at these two approaches. 

Put selling to gain a better entry price

With this put selling approach your goal as an option seller is to gain a better stock entry with the added benefit of collecting a premium which again is usually between 2%-4%. This premium also lowers your cost basis on the stock position you are expecting to get assigned.

As long as you’ve done some solid analysis on the stock, getting assigned the shares you should be something you look forward to.
 

Put selling to generate income

When you sell a put option as an income generating strategy, this means your strategy is to never get assigned any shares. This approach is a little more advanced and it allows traders to safely make a return of around 2%-4% per month without any of the risks associated with stock ownership. Risk management is at the core of this strategy. Once you open a position and your trade goes against you, the safest thing to do is to close the position at a loss and open a new trade.

There are some positives and negatives to each of these Put selling strategies. 

Risk and reward of each Put selling strategy 

Again, selling put options to generate income is a slightly less risky approach because you are automatically risking less capital. In our PayPal example you would need about $6700 to purchase those shares in case of assignment; consider that if PayPal shares drop 20% or more from the time of your purchase, you’d be down big on your position and might be forced to hold the shares longer than you would’ve wanted to.
 

 Put selling in the hopes of gaining a better stock entry might have downside risk which means the stock might go down even more before it goes back up, but I would describe the risk of put selling for income generation as being the complete opposite, consider that since you never own the shares you always run the risk of missing out on the upside potential of the stock. 

 Both worst case outcomes for each strategy are okay in my opinion. There is some level of risk with every option trading strategy, the objective is to understand and manage those risks. 

Research and prepare
 

 Consider that if you’ve done your research and have determined that a company’s shares are significantly undervalued relative to its fair value, you shouldn’t blink if the stock drops below your entry point. It might even be a perfect opportunity to purchase more shares. 

 Once the market recognizes the price mismatch that company’s shares have the potential to rally 30% or more. Those returns would far outweigh the 2%-4% return you would’ve been making from your income-generating strategy.  

The key is to do a good fundamental analysis of all the stocks you trade, and, if you determine that you were wrong in your assessment of the value of the company, don’t be afraid to cut your losses and move on.
 

My goal with this article is to have Cash-Secured Puts explained in a way that can be actionable shortly after reading this article. This strategy can be a powerful tool for investors seeking income generation and the opportunity to acquire stocks at a discounted price. 

 By understanding this concept, and its advantages, plus the risks associated with this options trading strategy, anyone can be successful and make informed decisions aligned with their financial goals and risk tolerance. 

If you liked this post, check out our post on covered calls to learn more ways to make additional income from your stocks. 

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What are Options?

Before diving into the world of option trading, let’s start with the basics of call and put options. Options are financial derivatives that give the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price (known as the strike price) within a specified timeframe. The underlying asset can be stocks, indices, commodities, or even currencies.

Call Options

Call options provide the buyer with the right to buy the underlying asset at the strike price within the specified timeframe. Traders usually purchase call options when they anticipate an upward price movement in the underlying asset.

Put Options

Put options, on the other hand, give the holder the right to sell the underlying asset at the strike price within the specified timeframe. Put options are typically used when traders expect the price of the underlying asset to decline, or if they are looking to protect against downside losses from one of their stock positions.

Option Greeks

Options Greeks help you understand exactly what is going on with a call or put option you own in relation to the stock price. It’s easy to understand that if you buy a call option and the price of the stock goes up the value of your call option will also go up, but by how much? Option Greeks like Delta, Gamma, Theta, Vega, and Rho help understand the correlation between how much an option will increase if the stock goes up by 5%.

Advantages of Option Trading

Option trading offers several advantages that make it an attractive strategy for investors. You have the potential for higher returns through leverage, the ability to profit in both rising and falling markets, all while managing the limited risks associated with options through good risk management practices.

Option Trading Strategies

Option trading provides a variety of strategies that traders can employ to achieve their investment goals. covered calls, cash secured puts, protective puts, long calls, spreads. These different approaches encompass income-generating strategies, hedging strategies for wealth protection, and speculative strategies for potentially explosive gains.

Risks and Risk Management

As with any investment strategy, option trading carries risks. It is crucial to understand and manage these risks effectively. The best way to achieve this is by minimizing your exposure on every trade. Someone with a smaller portfolio might be more aggressive searching for large gains, where as someone with a bigger portfolio might opt for a safer approach centered around wealth protection.

Getting Started with Option Trading

To begin your option trading journey, you’ll need to open an options trading account with a reputable broker. The main difference between brokers in my experience, is the ease of use of the platforms, and the fees and commissions they charge. One of your main goals as an option trader is to maximize your gains as best as you can. As you gain experience, you’ll discover which brokerage best aligns with your trading style, whether it offers a simple user interface or advanced charts and data.

Educating Yourself

Option trading requires continuous learning and staying up-to-date with market trends. The broker you use will have a lot of educational content to help you maximize your trades and improve as an option trader. I always do my best to follow anyone that I feel might have more experience than I do to learn from their experiences and take what works best for me to improve. Twitter is a great resource and there are plenty of option investor who are open and provide their knowledge at no cost. 

Option trading can be an exciting and profitable investment strategy, but it’s essential to understand the basics of call and put options before diving in. In this article, we covered some of the fundamental concepts of option trading, explored its advantages, and highlighted key considerations for risk management. Armed with this knowledge, you can embark on your options trading journey with more confidence. There will be some bumps on the road, but continue to build your expertise, the rewards are worth it. 

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Every buyer of an option has a seller on the other side—an easy concept to grasp, but not something I’ve spent much time pondering in the broader context of option trading. This becomes particularly relevant when you’re actively using an option strategy with assignment risk, such as a covered call strategy. 

 Why should you consider selling covered calls?  

Covered calls give individual investors the ability to increase their market returns by leveraging each 100 shares they hold in their portfolio, far beyond what a traditional buy-and-hold investor would achieve. Personally, I became a fan of this strategy because, when used wisely, it carries a very low risk of significant losses. And if you’re familiar with options, you know that significant losses are often associated with most option traders. 

 How to get started: 

 If you’re new to trading and don’t own any stock positions, your first task is to go shopping for some stocks. To enact the covered call strategy, you need to have at least 100 shares of a particular stock. Everyone has a different approach based on their risk tolerance, but let’s say you have $5,000 that you’d like to deploy into the market. My strategy would be to look for 5 stocks that cost $10 or less to add to my portfolio. It’s worth mentioning that the method you use to pick those stocks is crucial—you should have solid fundamental or technical reasons for selecting them. 

 Due to the nature of selling covered calls, I know that my hypothetical $5,000 portfolio will be a high-risk one filled with speculative stocks. These are companies that are not yet profitable but have significant upside potential. I’d structure my portfolio this way because option selling revolves around collecting premium, which is the money you receive for taking on the risk of potentially losing your shares. The amount of premium you receive is tied to the implied volatility of the option, which is mainly influenced by the risk-reward profile of the stock in question and any significant news events that fuel speculation about the stock’s future price movements.  

The riskier the stock, the higher the premium you receive. Take stocks like Palantir or Sofi, for example. Owning these stocks involves perceived risk since they recently went public, but their future prospects look promising, and the market loves to speculate on their growth potential. 

 How does selling a covered call work? 

By now, we’re halfway through this post, but can you answer the question of how does selling a covered call work? In my newly built portfolio of stocks, I now own Sofi. Let’s examine how much we can potentially earn on a weekly or monthly basis from this position. The number of trades you can make in a month will depend on your work and personal life. Let’s assume you can trade once a month; a good rule of thumb is to aim for a return of around 2% to 4%. I’ve found that focusing on those returns has brought me the most success and consistency in my trades. 

 Sofi is currently trading at $5.39 per share as of May 24th, 2023. So, a 100-share position in the stock would be worth $539. We’re aiming for a roughly 4% return on this stock, which amounts to approximately $20 worth of premium collected in a month. Let’s dive into an example: to open this trade, you would sell a call on Sofi at the $5.50 strike price with an expiration date of June 23rd, 2023. The premium received for this option is $27. By June 23rd, if Sofi is trading at $5.50 or higher, you would be obligated to sell your shares at that price. Additionally, you would receive $0.11 per share for the stock if we assume you purchased it at $5.39. This would result in a total return of $38, equivalent to around a 7% return in one month. 

 The above example is simplified, mainly focusing on the trade breakdown. Initially, you may experience a few losses, but over time, you’ll gradually determine your win rate. It’s ideal to aim for a win rate of around 85% to 90% of your trades. If you find that you’re losing a significant number of trades, take the time to identify what might be going wrong and adjust your approach accordingly. Commissions play a significant role in your options trades, as the fees you pay per trade directly impact your returns. Research online platforms that offer free or low commissions to find the one that works best for you. 

 The biggest risks of selling a covered call:

1. Risk of missing returns: Consider a scenario where the Sofi stock goes up 10% over the month you sold your covered call. Comparing that increase to your trade, you would have missed out on approximately $53, which is a difference of about 3% from your original trade. This is one of the significant risks of covered calls. 

1. Stock price decline: Let’s say you bought the shares at $5.39, but the stock price drops to $4.50 per share. This means you would be down approximately 16% on your position. If you made the same trade and were forced to sell the stock at $5.50, which is below your cost basis, you would have incurred an overall loss of about 9% after considering the 7% return you initially made. 

1. Assignment risk: When selling calls on a stock with a dividend, such as Apple, the counterparty may exercise their right to buy the shares before the expiration date if the stock’s ex-dividend date coincides with the option’s expiration date. They do this to collect the dividend and boost their returns, and that can only happen if they own the shares before the ex-dividend date, leading them to exercise their right to purchase your shares earlier than you intended. 

1. Opportunity cost: This scenario becomes a concern when you make poor decisions regarding the stocks you choose to purchase when selling covered calls. Always keep in mind that you may need to hold the stock for a long time if there is a significant decline in the stock market. Therefore, ensure that the stock you purchase is one you like, so you can purchase more shares as the price drops. 

 Now, how does selling a covered call work? There is much more to the strategy of selling covered calls, but I hope this post at least sets you on the right path. Experience will be your best teacher. Trial and error will help you perfect your strategy but remember not to put your entire portfolio at risk on one trade. Over time, you will become more comfortable and confident, and what initially seemed like a large risk will no longer feel that way with your growing experience. Many platforms offer trading simulators for practicing paper trading before you start with real money. This can be a great approach to limit the risk of losing money as you get started. 

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While a simple buy and hold strategy of the S&P 500 index is suitable for most people, I have always been a hands-on investor. Instead of the traditional approach of investing in a 401k and aiming to become a millionaire by 65, my goals were always to achieve more. I wish I had known more about low-risk, high-reward option strategies such as buying long calls, puts, selling cash-secured puts, and selling covered calls, which can significantly boost market returns when executed correctly. 

So, why should one trade options? 

For a while, I felt quite pleased with myself as a few of my individual stock positions gained 25-30% over a two-year period, seemingly beating the market. I believed that consistent investing of at least 10% of my paycheck each month would bring me closer to my financial goals. However, it was during the pandemic, when I witnessed market crashes and the rapid erosion of market returns, that I was introduced to options and the first strategy I learned of is hedging, which is essential in option trading. 

As I watched all my positions lose their gains, I felt a sense of helplessness. It seemed like my only options were to either panic sell all my positions or hold onto them, hoping for a rebound which could’ve taken weeks or even years. However, as I learned more about options, I discovered a third alternative. 

Protective Put: 

Selling stocks in which you still have faith, particularly if the company’s fundamentals remain strong, is never ideal. Hedging, a commonly used option strategy, protects against losses when a company’s stock price is falling. By purchasing a protective put option, you can safeguard yourself from further losses. For instance, if your cost basis on a stock is $45 per share, you can buy a put option at the $40 strike price, with a future expiration date of 3 months to a year. This way, if the stock price falls below $40 at any point during that period, the increasing value of the put option would offset the declining value of your stock. 

Getting started with option trading: 

If you’re considering venturing into option trading, I encourage you not to make options your primary focus right away. First, determine the type of investor you are or want to be. Are you a value investor who prefers holding blue-chip names like Coca-Cola and Apple? Or are you a growth investor with a higher risk tolerance, looking for companies like Nvidia, AMD, and Tesla? The reason I stress this point first is because the positions you buy, hold, and trade will form the foundation of everything you do with options. 

The Wheel strategy: 

One of the most popular option trading strategies is the Wheel strategy. The first part of this strategy involves a put writing strategy known as a cash-secured put. To begin, you need to choose a stock you want to buy and determine a price at which you would be comfortable owning it. Then, you sell a put option on that stock at a specific strike price, which means you have the obligation to buy 100 shares of the stock if it reaches that strike price before a predetermined expiration date. 

For example, let’s consider Tesla stock, which is currently trading at around $164 per share. If you believe this price is too high, you could decide to sell a put option with a strike price of $150, expiring three months from now (the week of July 21st, 2023). This put option would pay you a premium of about 5% or $890. 

If you have a bullish long-term outlook on Tesla but don’t want to pay too much for owning it, you wouldn’t be disappointed if the stock price dropped to $150. If Tesla doesn’t drop to $150 per share by July 21st, you keep the premium without any obligations, and you can open another position to collect more premium. You can repeat this process over and over. The only requirement for this strategy is having the collateral ($15,000) to take ownership of the shares. Since stocks don’t only go up, eventually you may be assigned the shares. 

On the other side of the strategy, there is a potential downside. For instance, if the stock price falls to $125 per share, as the option seller, you are still obligated to buy the stock at $150 per share. This would result in starting your position in Tesla down by $25 per share or 15%. However, there is some good news. Remember the $890 you received initially? Well, that premium factors into your cost basis. So even though your position is down, your cost basis is technically around $141 per share instead of $150 per share, meaning you are down by approximately 11%. 

Another positive aspect is the ownership of the shares. If you have strong conviction in the long-term outlook of Tesla or any other company you like, you would be pleased to own the stock at a discounted price. Once you own some shares, you can move on to the second part of the Wheel strategy: covered calls. 

Covered calls: 

Now that you own 100 shares of Tesla, you can write a covered call. In this strategy, you essentially put your shares up for sale by selling a call option at a predetermined strike price. By doing this, you have the obligation to sell those shares if the stock reaches that strike price, and in return, you receive a premium. Let’s continue using Tesla as an example. 

Assuming Tesla shares are currently trading at $164 per share, instead of merely holding the shares and waiting for them to appreciate over time, you can sell a $185 call option expiring on July 21st. By doing so, you collect a premium of approximately $735, which translates to roughly a 4% return over two months. Essentially, if Tesla reaches $185 per share by July 21st, you will have to sell your shares at that price, regardless of how high the stock price goes. 

At first glance, it may seem like a favorable outcome. You gained $21 per share in share price appreciation, along with the collected premium, resulting in approximately $2,835 in profit from your Tesla shares. 

Making a profit is always a positive outcome, but you may later realize the missed potential. For instance, let’s say shortly after this trade concludes, Tesla’s stock price rises to $200 per share or even higher. This means you would have missed out on the additional upside potential of the stock. 

This is where your outlook for the company becomes crucial. If you believe the stock still has more room to grow, you can choose to buy back the call option and accept a loss on the position. Keep in mind that buying back the call option would likely be more expensive than the $735 premium you received, depending on how much the share price increased.  

Alternatively, you can be less aggressive in choosing the strike price of the calls you write by opting for higher strike prices, such as $190 or $195. This reduces the likelihood of the stock reaching that strike price but also lowers the premium you would receive. People are often enticed by writing aggressive calls to generate higher premiums on their stocks. 

Investing in any asset always involves a risk-reward factor, and we take on risks in hopes of better returns. The objective is for those returns to surpass what we could achieve by investing in savings accounts or bonds. This mindset guides me when weighing the pros and cons of any option strategy I utilize. 

It’s easy to get caught up in the excitement of turning $1000 into $10,000, and many individuals who engage in option trading have experienced the thrill of chasing those returns. However, after learning some lessons the hard way, they typically abandon strategies that fell more like gambling and instead seek more stable and risk-defined strategies, such as the ones we discussed. 

These strategies are just one of several utilized by prominent hedge funds in the public markets. I used all the resources available to me to reach a point where I felt less overwhelmed and confused when considering how to implement these strategies, trial and error was the best teacher for me personally. Check out the Chicago Board Options Exchange to learn more about option trading, jumping right in usually results in financial loss. Your brokerage account might also have some great resources you can utilize as well.  

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