Selling covered calls could help generate income from stocks you already own
Selecting strikes and expiration dates depends on the desired risk and reward trade-off of the position
Take a step-by-step look at how to trade a covered call
So you own a bunch of stocks in your portfolio. Some have made a decent profit. You’ve heard you could potentially generate income from stocks you own by trading options. It sounds like a great idea, but options trading seems complex, mysterious, and maybe even a tad bit intimidating. What’s the best way to start learning how to trade options?
First off, it’s best to understand what options really are. Options were designed to transfer risk from one trader to another. There are basically three reasons to trade options: as a speculative tool, as a hedge, and to generate income.
When trading options, one thing you’ll learn quickly is that there are many choices and strategies. There’s no one right way to trade options. It’s really about your objectives and risk tolerance.
Lay of the Land: How to Trade Options
First things first: You’ll need to have options approval. Log in to your account at tdameritrade.com. Under the Client Services tab, select My Profile. Under the General tab, you’ll see your approval status for options trading. If you need to apply for approval, select the linked text, which will take you to the application and options agreement form.
Once you have approval, you’re ready to begin your options trading journey. A good starting point is to understand what calls and puts are.
A call option is a contract that gives the owner the right to buy 100 shares of the underlying security at the strike price, any time before the expiration date of the option. The seller of the option has the obligation to sell the shares if the owner “exercises” their right to buy.
A put option is a contract that gives the owner the right to sell 100 shares of the underlying security at the strike price, any time before the expiration date of the option. The seller of the option has the obligation to buy the shares if the owner “exercises” their right to sell.
- Selling call options. The seller of a call option assumes the obligation to supply the underlying asset at the strike price if and when the call contract is “exercised” by the buyer. When this happens, the option seller is said to be “assigned.”Selling put options. The seller assumes the obligation to purchase an underlying asset if and when the put contract is “exercised” by the buyer.
- Buying call options. The buyer of a call option has the right (but not the obligation) to purchase the underlying stock or index at a specific price (the strike price).Buying put options. The buyer has the right (but not the obligation) to sell the underlying asset at a specific price (the strike price of the option).
Don’t worry if words like assigned, exercised, obligation, and so on seem confusing. They’ll start to make more sense as you gain experience and become more educated about options trading.
Dipping One Toe in the Water: How to Sell Covered Calls
If your objective is to earn some income on your stock positions, you could consider selling or “writing” a covered call.
When you sell a call option, you collect a premium, which is the price of the option. That premium is the income you receive. But that doesn’t mean you should always go after the options with the highest premiums. It’s best to understand the risk/reward trade-offs by looking at how much you’d be risking versus how much you’re likely to gain. For example, the risk profile of a covered call in figure 1 shows that the profit is limited and the risk is almost unlimited.
FIGURE 1: RISK PROFILE OF COVERED CALL. Note that the upside potential is limited and the downside risk is essentially unlimited—at least, until the stock goes down to zero. For illustrative purposes only.
Also, remember that each options contract has an expiration date. That means you can’t sit on an option indefinitely just waiting for the price to reach your desired level.
Okay. Let’s get started with an example of your first options trade. One standard options contract represents 100 shares, so choose a stock from your paperMoney® portfolio that:
- You own at least 100 shares of Is trading at a higher price than where you bought it so if the option gets assigned you could sell the stock at a price you’re comfortable withYou think will move up slightly—or not at all—in the short term
Step 1. Analyze the options.
Open up your paperMoney account on the thinkorswim® platform from TD Ameritrade (see figure 2).
FIGURE 2: LOTS OF CHOICES. From the Trade or Analyze tab, you can see all the different options expiration dates and the strike prices within each of those expiration dates. Chart source: the thinkorswim platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.
Select the Trade tab, and enter the symbol of the stock you selected. You’ll see the usual details of the underlying stock at the top of the page. Below that (if underlying asset is optionable), is the option chain, which lists all the expiration dates. Each date has several strike prices, which you can see when you select the down arrow to the left of the date. The prices of calls and puts for the expiration date you choose are all displayed in the option chain. Calls are displayed on the left side and puts on the right side. All the data you see is organized by strike price. Note that you can change the layout to display the variables you want to see (but customizing your layout is something you’ll do as your skill level advances).
Step 2. Choose the expiration date and strike.
When starting out, consider choosing an expiration that is three weeks to two months away (the number of days to expiration is in parentheses next to the expiration date), although there are no hard and fast rules. The expiration you choose should give you a premium that’s worth the risk you’re taking. The strike you sell versus the underlying stock’s current price can make a big difference in the trade’s risk/reward profile.
That brings up another important decision. Do you sell a call with a strike price that’s the same as (or close to), higher than, or lower than the current stock price?
- When the strike price is less than the price of the current stock price, the call option is in the money (ITM). When the strike price is the same as the stock price, the call option is at the money (ATM). When the strike price is higher than the stock price, the call option is out of the money (OTM).
If you’re bullish on the stock, you may consider selling an OTM call. The premium will probably be lower than an ATM or ITM call, but if the price of the stock appreciates, you could make more profit. If your outlook is neutral, then you may want to write an ATM or ITM call. You may collect more premium than the OTM call, but with less upside profit potential for the stock and a higher probability of assignment.
Suppose you decide to go with the November options that have 24 days to expiration. The stock is trading at around $52, and you want a strike that’s slightly OTM. So you go with the November 53 strike call at $1.04. That means you collect $104 in premium. If you’re comfortable with the risk/reward trade-off—and if you’re not, there are plenty of other choices—you’re ready to place the trade.
Remember the Multiplier!
For all of these examples, remember to multiply the options premium by 100, the multiplier for standard U.S. equity options contracts. So an options premium of $1 is really $100 per contract.
Step 3. Place the trade.
FIGURE 3: PLACING THE TRADE. From the Trade tab, select the strike price, then Sell, then Single. Chart source: the thinkorswim platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.
From the Trade tab (see figure 3):
- Click on the bid price to create the orderSelect SellSelect Single
Step 4: Send the order.
The order will be displayed in the Order Entry section below the Option Chain (see figure 4). Note that the price could change by the time you place the order.
FIGURE 4: ORDER ENTRY. Before placing the trade, you get a chance to review the order in the Order Entry section. It’s a good idea to double-check all the trade parameters. Make sure you change the number of contracts to one. If all looks good, select Confirm and Send. Chart source: the thinkorswim platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.
When you select Confirm and Send, you’ll see an order confirmation dialog with details such as break-even price, max profit, max loss, and cost of the trade (or how much credit you’ll receive after any transaction costs such as commissions, contract fees, etc.). If you like what you see, then select the Send button and the trade is on. When it’s filled, pat yourself on the back—you’ve made your first options trade.
But Wait, There’s More
Even though you placed your options trade in a simulated account, don’t just forget about it. Take advantage of the opportunity to observe how the trade works out. There are three possible scenarios:
- The stock price declines. Your option expires worthless, and you get to keep the premium but your stock holding decreases in value. The stock price doesn’t move much and stays below the strike price. Your call option expires worthless, and you keep the premium.The stock price goes above the strike price. The option buyer (who bought the call from you) may exercise the call, which means you’ll have to sell 100 shares of the stock at the strike price. You still made a profit (premium plus the difference between the strike price of option and price paid for the stock, minus transaction costs). Remember that a short option can be assigned at any time regardless of the ITM amount. The early assignment can’t take place in a paperMoney account but will be assigned at expiration if the stock closes 0.01 ITM. In a real money account, assignment is possible at any time up through expiration.
Remember, there’s a whole universe of choices and strategies when it comes to trading options. Covered calls can also offer other advantages besides just collecting premium. You’ve taken the first step by selling a covered call, but that may open up many more doors. With practice, you’ll better understand how to manage risk, learn to modify strategies, get a better grasp of probability, and so on. So go on, explore your options!
Your First Trade
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Investing Basics: Covered Calls