[Options ABC] Covered Call: Is It a Beginner-Friendly Strategy?

Moo Options Explorer wrote a column · Dec 6, 2023 02:46

Hello everyone and welcome back to moomoo. I'm options explorer. In today's [Options ABC], we'll be taking a look at a strategy that can help you potentially earn additional profit while also providing a take-profit mechanism: Covered Call.

Wordcount: 2000
Target Audience: Investors who want to utilize options to enhance their stock trading strategy.
Main Content: How to construct a covered call strategy? What are the ideal scenarios for covered call? How to roll over a covered call?

In the first half of this year, the AI boom and ChatGPT hype contributed to the surge of several related US concept stocks. Among them, shares of NVIDIA $NVIDIA (NVDA.US)$ jumped from US$150 at the beginning of the year to a high of US$502, while Amazon $Amazon (AMZN.US)$ stock rose from US$85 to US$140.

[Options ABC] Covered Call: Is It a Beginner-Friendly Strategy?

(This chart traces the performance of Nvidia from December 2022 to September 2023. Any app images provided are not current and any securities shown are for illustrative purposes only and is not a recommendation.)

If you were fortunate enough to make satisfying profits by investing in these two companies, congratulations! However, purchasing a stock is only half the transaction; selling it to lock in profits is equally crucial. If you've achieved your primary objective and want to take profits, how would you go about it?

While some investors opt for a limit order to sell their stocks, what if the stock remains stagnant or fails to rise and never reaches your target price? This could result in a loss of valuable time and opportunity costs.

In light of this, some investors may try Selling Covered Calls.

1. Covered Call is not a 10 out of 10 strategy

Simply put, the Covered Call strategy involves selling call options on a stock you already own. A covered call is a bullish strategy that involves buying 100 shares of the underlying stock or ETF and selling a call option. You might consider this strategy if you expect a stock you hold for the long term won't rise dramatically in the short run. The call you sell helps hedge your long position, and the premium earned might enhance your potential income.

Let me explain the ideal scenario for this strategy based on its construction.

On the one hand, buy the shares. This trade suggests investors are bullish on the stock.
On the other hand, sell the call options. This trade alone suggests investors are not that confident the stock will go up.

Hence, the covered call strategy can be considered when one investor believes the stock will go up in the long term, but doesn't think it will rise substantially in the near term.

When building the Covered Call strategy, some investors may set the strike price of the option to their target selling price for the stock.

In such a case, if the stock price doesn't reach the target price by expiration, they keep the stock and earn extra income from the option premium.

If the stock price rises to the target price by expiration, they can sell the stock at the target price while also earning the option premium, further reducing their cost basis.

Sounds super easy, right? Don't get too excited just yet.

Let’s take a look Alice's example. Let's say Alice owns 100 shares of Amazon, priced at US$140. She has already achieved her investment objective by making a 30% profit and is eager to cash out. At the same time, she doesn't want to miss out on any potential uptrend as Amazon's momentum is strong. So, Alice decides to build a Covered Call strategy and sells a call option expiring next month with a strike price of US$150.

As the seller, Alice can receive a premium for selling the call option. What are the possible scenarios that could occur before expiration?

Scenario 1: The stock price fails to rise above US$150 by expiration, and the buyer does not exercise the option. In this case, Alice earns the option premium without having to sell the stock.

Scenario 2: The stock price rises above $150 by expiration, and the buyer chooses to exercise the option. In this case, Alice can sell her Amazon shares at the target price and earn the option premium, further reducing her cost basis.

However, real-life scenarios are much more complicated than these two simple scenarios. Let’s face reality and break the illusion.

Scenario 3: The stock price plummets sharply before expiration. In this case, Alice may opt to sell a portion of her stock to protect her profits. However, if she sells her entire position, the Covered Call becomes a naked call option, which carries unlimited risk. Before she sells out her entire position, she would need to get approved by her broker-dealer. Hence, there is a possibility that she could not sell out her stock position in advance at all.

Scenario 4: The stock price rises above US$150 before expiration, and the buyer requests early exercise. This result benefits Alice in several ways. First, Alice can sell her shares at the target price, realizing her investment goal. Second, as the seller of the call option, Alice earns a premium, further lowering her cost basis. Third, the buyer's early exercise saves time costs and eliminates any unexpected events.

Scenario 5: The stock price first rises above US$150, but the buyer does not request early exercise. Then the stock drops below US$150. This is the least desirable scenario for Alice. Firstly, Alice misses an opportunity to sell at the target price. Secondly, Alice faces the dilemma of whether to sell her shares or not. If Alice sells her stock first but the stock price bounces back to US$150 at the expiration date, she'll have to buy the stock at US$150 and then sell it if the buyer request exercise, which incurs additional costs. If Alice doesn’t sell her shares in advance, she will lose the opportunity to sell out her positions at her target selling price. However, similar to scenario 3, before she sells out her entire position, she would need to get approved by her broker-dealer. Hence, there is a possibility that she could not sell out her stock position in advance at all.

Now that we've known the five possible scenarios, what should investors consider before using Covered Call?

2. What should you consider before using Covered Call?

While Covered Call strategies can be profitable, it is widely acknowledged that they are not suitable for all market conditions.

So, what is the potential market condition for this strategy?

In simple terms, Covered Call potentially works best for stocks with gentle upward trends. It is not recommended to use this strategy for rapidly rising stocks, as the short call limits the potential profit. Utilizing Covered Call on rapidly rising stocks could result in missing out on an excellent opportunity for profit beyond the exercise price. Additionally, Covered Call is not suitable for continuously declining stocks. Why? Although selling Call options earns a profit, the seller's income is always limited to the option premium collected. Losses from the stock decline often far exceed the premium collected, resulting in an overall loss for the strategy.

Now that we know the ideal market condition for Covered Call, what issues should be considered when constructing this strategy?

Don't forget to buy in stock first

In the US market, one option contract generally represents 100 shares of the underlying stock. Therefore, it is necessary to hold at least 100 corresponding shares of stock to construct a Covered Call strategy. However, in the Hong Kong market, an option contract may represent 200 or 500 shares of the underlying stock, and sometimes only 200 shares. It is important to pay attention when placing orders. If there are insufficient shares of stock owned, the Covered Call strategy will become an uncovered Call strategy, which is much riskier.

Two ways to construct Covered Call strategies on moomoo

Two paths to construct a Covered Call strategy on moomoo.

Path 1: Options Chain > Strategy > Covered Stock.

This method helps you complete two actions in one click: buy underlying stock's shares and sell call. When building this strategy, make sure to select selling Call options.

Path 2: Holding Stocks First > Options Chain > Strategy > Single Leg > Sell Call

If you already own stocks and wish to construct a Covered Call strategy, simply place an additional order for a single-leg option and sell the corresponding number of calls. However, if you intend to sell the underlying stock after constructing a Covered Call in this way, the combination will not enjoy margin reduction. In such a situation, if your account risk value falls below zero, forced liquidation will be triggered.

If a stock experiences a significant decline, roll down may help stop loss.

As mentioned earlier, if a stock experiences significant drops, the Covered Call strategy may result in an overall loss. However, there are other choices besides closing the entire position, such as the Roll Down method. Depending on different market conditions, investors can use this method in various ways.

One approach is to buy back the short Call while simultaneously selling a call with a lower strike price. By doing this, investors can effectively reduce the break-even point of the entire strategy and control risks.

The other approach is to buy back the sold Call while simultaneously selling an option that expires on a different date from the current one. For example, if Alice sells a Call that expires at the end of next month, and the stock price enters a downturn, she can roll her position by buying back the Call and selling another Call that expires in the following week. However, this process is not 100% safe and Alice can potentially lose money when buying back the covered call. After the expiration of the option next week, Alice can collect the option premium and decide whether to sell other options. However, investors should keep in mind that this roll down does not guarantee profits. It is likely for Alice to lose money during this process. For example, if the stock price climbs up after Alice sells the call, she will lose money and face unlimited risks.

That's all for today! Please feel free to leave a comment if you have any questions or thoughts. Don't forget to follow us to stay up-to-date on all things related to options trading. For more information of options learning, you can click on the image below to follow me immediately!

Risk Statement

The examples provided herein are for illustrative and educational purposes only and not intended to be reflective of results any investor can expect to achieve. The figures shown in the examples are not guarantees or projections, and no taxes or fees/expenses are included in the calculations which would reduce the figures shown. Actual results will vary.

Moomoo is a financial information and trading app offered by Moomoo Technologies Inc. In the U.S., investment products and services on Moomoo are offered by Moomoo Financial Inc., Member FINRA/SIPC.

This article is for educational use only and is not a recommendation of any particular investment strategy. Content is general in nature, strictly for educational purposes, and may not be appropriate for all investors. It is provided without respect to individual investors’ financial sophistication, financial situation, investment objectives, investing time horizon, or risk tolerance. You should consider the appropriateness of this information having regard to your relevant personal circumstances before making any investment decisions. All investing involves risks. Any examples are provided herein are for illustrative purposes only and not intended to be reflective of results any investor can expect to achieve.

Options trading entails significant risk and is not appropriate for all customers. It is important that investors read Characteristics and Risks of Standardized Options (https://j.us.moomoo.com/00xBBz) before engaging in any options trading strategies. Options transactions are often complex and may involve the potential of losing the entire investment in a relatively short period of time. Certain complex options strategies carry additional risk, including the potential for losses that may exceed the original investment amount. Supporting documentation for any claims, if applicable, will be furnished upon request.

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