If you are going to do covered call trades, then be aware that it is not a conservative trade and be prepared to make a challenging decision when the options expiration date arrives. Here are some suggestions for handling covered call trades:
Now let’s get back to comparing a covered call with selling a naked put. To see that these two trades have the exactly the same risk and reward characteristics, examine cases in which the stock price at expiration is either above or below the strike price of the option. To make things definite, consider a specific example.
Covered call: With XYZ at $53, you buy 100 shares of stock and sell one 55 call option for $2.0 per share. This means that you have equivalently purchased 100 shares of XYZ for $51 per share. If the XYZ has fallen to $40 per share at options expiration, you will have lost $1100 on this trade. The maximum reward that you can receive on this trade is $400, which occurs when the stock price exceeds $55 at expiration.
Naked put: With XYZ at $53, you sell one 55 put option for $4.0 per share, which pays you $400. If XYZ has fallen to $40 per share at options expiration, the option will be exercised and you will be required to buy the stock for $55 per share. Subtract the $400 you received and your loss on this trade will be $1100. The maximum reward occurs when the stock price exceeds $55 at expiration and you get to keep the $400 received from the sale of the put.
Unfortunately, the covered call trade is not nearly as straightforward as the idealized description would suggest. Stock prices undergo considerable fluctuation over time and, all too frequently, the stock price on the expiration date will be either well above or well below the strike price of the short call. Both scenarios present a difficult decision going forward.
If the stock price is much higher than the strike price of the call at expiration, you may be reluctant to give up your stock at a price that is well below its current level, and thus forego any future gains in the stock price. The only alternative is to buy back the short call for a significant loss in order to continue holding the stock. If the stock then fails to perform as expected, it may be quite difficult to make up for the loss incurred from buying back the short call.
If the stock price is much lower than the strike price of the call at expiration, you keep the stock, but you are faced with the challenging decision of which call strike to sell for the next option cycle. If you sell a high strike in order to give the stock price room to move up, the cash received from the sale may be miniscule. On the other hand, if you sell a strike nearer to the current stock price in order to receive more cash, you lose the opportunity for the stock to regain all of its lost value.
Here is the idealized description of what happens when the call option expires. If the stock price is above the strike price of the call at expiration, your stock will be called away for a price that is presumably higher than your original purchase price —- you have made a profit on the price increase in the stock and you also have the cash received from the selling the option. If the stock price is below the strike price of the option at expiration, then the option expires worthless and you keep your stock —- you again have the cash received from selling the option, and you are free to repeat the process by selling another call in the next option cycle. As you can see in this idealized version, the covered call trade has the potential to generate regular profits by repeatedly selling call options against stock that you own.
TRADING COVERED CALLS is frequently one of the first strategies that someone new to options learns to do. In its simplest form, the covered call trade requires that you own 100 shares of stock. Then you can sell one call option, which represents 100 shares of the underlying stock. Typically you sell a call that has a strike price above the current stock price. This allows you to benefit from the funds received from the sale of the call, as well as the potential gain in stock value as its price moves up to the level of the strike price. The call that you sell is said to be “covered” by the stock that you own, because if the option is exercised, your brokerage account has the stock that must be surrendered for sale at the strike price. The cash received from selling the call is yours to keep no matter what happens.
The trading of covered calls is often described as a safe and simple way to make money with options. Many brokerage firms allow covered calls as the only options trade that can be done in a retirement account because it is “conservative.” This description of covered call trades as conservative is somewhat misleading. Ask those same brokerage firms how they feel about selling naked puts in a retirement account. They will explain how that type of trade is much too risky to be allowed in a retirement account. The truth is that a covered call trade has essentially the same risk-reward characteristics as selling a naked put. And selling naked puts is risky.
The covered call trade is only conservative from the viewpoint of the brokerage firm. They have control of your stock and will immediately release it if the call option is exercised. On the other hand, if you sell a naked put and the price of the stock drops, your brokerage account may not have sufficient cash to purchase the stock if the put option is exercised. Your broker then has the non-conservative task of getting you to either add cash to your account or to sell other stock in your portfolio to supply the needed funds.
To clarify, while the overall risk-reward of the covered call and naked put trades are similar, the effect to the investor can be different. A covered call implies the investor already owns the stock. The investor doesn’t need to bring any money to the table in this transaction regardless of what happens with the option. If a naked put goes against the investor, they will need to come up with the money to purchase the shares that are being put to them. This is why naked puts typically aren’t allowed in IRA accounts. Unless the cash is already available in the account, the investor can’t add more than the annual contribution amount to cover the cost of purchasing the shares.