Covered calls. One of my favorite strategies.
The CBOE said in a letter to the SEC that using a covered call strategy is actually safer than just owning the underlying stock.
And it’s not hard to see why.
Let’s use an example to demonstrate:
Let’s say you bought GOOG on October 17, 2023. Remember that date, it’s important.
After stair stepping its way up from about $90 early in 2023, the stock was hovering around $140 at that time.
56% gain on the stock year-to-date. Pretty darn good.
There was no reason to think that pattern wouldn’t continue.
So you plunk down $14,000 to buy 100 shares of GOOG.
Why $14,000? Because $140 per share x 100 shares = $14,000.
It might seem like a lot of cash — and it is — but the good thing about buying in chunks of 100 is that you can sell 1 call contract against every 100 shares you own.
So let’s say you own 100 shares of GOOG at $140.
Do you remember what happened over the next 10 days? Remember, we’re starting at October 17, 2023.
Here’s a visual:
The stock dropped almost 20 points when Google reported earnings. I won’t get into the reasons.
The important thing is that you now own something you bought at $140.
And less than 10 days later, it’s now worth $121.46.
That’s a 13% drop — pretty big drop in such a short time.
Now here’s the key thing: If you don’t know about covered calls, that’s it. You’re stuck.
You either sell at a loss. Or you wait for it to come back up.
Let’s say you wanted to be patient and wait. How long would your $14,000 be tied up for?
Take a look:
Look at how long it took for GOOG to get comfortably above $140.
Not to mention how many times it did a “fake out” where it barely touched $140 before dropping back down.
That was probably all those other folks like you who bought at $140 and were selling as soon as it touched $140, just to get out at a breakeven.
Meanwhile, that $14,000 was tied up doing NOTHING for them.
But not you, amigo. Because you’ve got me on your side.
Here’s what you could have done with covered calls if you found yourself in the same situation.
Create Your Plan
First of all, take a deep breath. It’s not the end of the world.
Google ain’t Enron — and as long as Google doesn’t go to zero, you’ve got an asset on your hands that you can use to create cashflow.
Next, let’s look at some options chains.
Now, when I tell people to look at options chains, they get cross-eyed sometimes.
I think they’re just intimidated. But there’s no reason to be.
Think of it this way: An options chain is just a menu of prices.
If you’re a buyer it’s a menu of prices you can pay to buy an option.
And if you’re a seller, it’s a menu of prices people are willing to pay you.
Plus, here’s the best part: If you don’t like the prices you see, you can:
- wait for prices to get better
- you can look at another part of the menu
- you can even put in a price you want to get and see if someone takes you up on it!
So let’s rewind to October 17, 2024. You had just paid $140 per share for 100 shares of Google.
You decided to follow my standard advice which is to sell a call that is 7-10% out of the money and 30-45 days till expiration.
So let’s turn back the clock and look at that part of the menu.
Round 1
First thing we need to do is find the part of the menu that lets us look at options expiring in the timeframe we want. (remember, 30-45 days from Oct 17th)
In the screenshot below, you can see at the top left hand corner it says 1 DEC 23.
That means those options expire on December 1, 2023.
Next thing we need to do is some quick math.
You own the stock at $140 and let’s say you decide you want to sell a call 7% above that.
That means 140 x 1.07 = $149.80.
So we’re looking for a strike price near $149.80. The closest strike price to $149.80 is $150.
The strike prices are listed in the column all the way to the right.
I’ve outlined the option that we are choosing with a yellow box.
Now, if you look at the BID and ASK columns, you can see the BID is at 2.43 and the ASK is at 2.48.
That means potential buyers who are offering to buy that option are bidding $2.43.
And potential sellers who are offering to sell that option are asking $2.48 for it.
Let’s assume you think $2.48 is fair. You put in your trade and wait.
Orders don’t always get filled right away. Sometimes the price runs away from you. It’s ok, you can adjust if needed.
Let’s assume after a few minutes you get filled at $2.48.
That means you now have received $2.48 for every share of GOOG that you own, which is $2.48 x 100 = $248.
Congrats! You just lowered your cost basis by collecting premium.
That premium hits your account instantly, by the way.
So those shares you originally bought for $140 are now $140 – $2.48 = $137.52.
Now the most important part.
Step away from the computer. Go live your life.
You’ve got 6 weeks until those options expire. No sense in sitting there staring at the screen waiting for something to happen.
So fast forward 6 weeks, Friday December 1st comes and goes. The option you sold expires worthless.
Now, most people hear “worthless” and think it’s a bad thing. But that’s only for the guy or gal that bought the option from you.
For you, “worthless” means you keep the cash you collected for selling that option and you have no further obligation.
In other words, the agreement you made to sell the stock at $147 is expired.
Go enjoy your weekend and come back Monday, because we start fresh again.
Round 2
Ok, fast forward to Monday. It’s December 4th.
Let’s just say you look at the options chain and don’t like what you see. Google just dumped off over the last few days.
You think it’s just temporary, so you decide to wait a bit.
You do some quick math and figure when GOOG is at $133, 7% above that is $142.31.
You’ll sell the $143 Call.
The very next day GOOG spikes up 3% so you make your move.
You pick an option that’s 30 days away: Jan 5th $143 strike for 54¢.
BOOM! Again your cost basis comes down.
$137.52 – $54 = $136.98.
Again, step away for the next 4 weeks.
During those 4 weeks, GOOG was briefly goes above $143, which is the strike price you sold.
So, while your 100 shares of GOOG could technically bae “called away” from you, it’s very unlikely.
That’s because most options are traded, not exercised.
By January 5th GOOG closes the day at $137.
Rinse and repeat: You still own the shares and you keep the premium.
Round 3
You log on Monday morning, January 8th and you see GOOG is quickly rising.
You decide to watch it for a little bit.
After all, the higher GOOG rises, the higher the strike price you can sell.
About halfway through the day you decide to pull the trigger.
By this time you’re wise. You look ahead on the calendar and see that GOOG is reporting earnings on January 30th.
You remember that you were able to collect a nice fat premium when you traded over earnings, so you look for an expiration that closes after earnings.
Can you can even prove this to yourself. Because when you look at the Jan 26 $150 Call, it’s only going for 32¢.
But when you look at the Feb 2 $150 Call, you’re getting $1.22.
You’re a pro now. You sell that Feb 2 $150 Call for $1.22.
Your cost basis was already down to $136.98.
Now you subtract $1.22 from that and end up with a cost basis of $135.76.
And remember, you’ve sold the $150 call, so if GOOG goes above $150 at any point between now and expiration day (Feb 2), you could be called out.
And in January, the market is absolutely loving GOOG. The stock quickly rises past $150. All the way to $155.
As I said before, it’s not very likely — but when you sell an option and it goes in-the-money*
*This is a new term I’m using, so let me explain what it means: In-the-money means that the price of the stock has gone above the strike price of the call option.
So, as in this example, when you sold a $150 Call option and GOOG’s stock price goes above $150, your call option that you sold is now considered to be in-the-money.
Anyway, just so we can close out this example, let’s pretend the buyer of your $150 Call decides to exercise the option early.
Your 100 shares of GOOG are called away from you for $150/share.
Remember, because you’ve been selling calls the whole time, the shares that you originally bought for $140 now cost you $135.76.
So your total profit? Easy: $150 – $135.76 = $14.24
And remember, we’re always talking about 100 shares, so multiply that $14.24 x 100 = $1,424.
That’s pretty nice, huh? From mid-October to early February, so 3½ months.
And that’s just with 100 shares. If you do this with 200 or 300 shares, you can imagine how much you’re bringing in.
And in terms of percentages? That’s over 10% in 3½ months!
Critiques and Comparisons
The very first thing I’ll address here is that some people say 10%? Can’t I buy a call option and have it double in a week?
Yes, that’s a valid critique. But the flip side of buying call options is that the vast majority of options expire worthless. (That’s why I love SELLING options.)
So that speculative option you buy, hoping for a 2x or 3x gain, could even more easily go to $0 and leave you with a -100% loser.
I’ve always said that after a few years of trading, you really learn what kind of person you are.
Some people are attracted to this “small”, consistent growth. Others are attracted to the big, flashy 100% gains in a week.
What I’ll say about that is that the road to wealth is not paved with 100% winners.
Next, let’s compare the covered call strategy to just buying the stock outright and holding it.
In the example above, GOOG really fought us. It went up, it went back down.
It’s not the ideal scenario — but I wanted to give you what most people think of as the “worst cast scenario” so you could see just how useful it is to constantly be reducing your cost basis by selling covered calls.
The ideal scenario is one where the stock is trending and continues trending. That way you can keep selling higher and higher strikes for more and more money.
And when you eventually get called out, you’ve been padding your gains on “both sides” by reducing your cost basis as the stock grows in value.
I’ll cover trending stocks in one of my future tutorials so you can find out how I pick the strongest trending stocks in the market.
Lessons Learned
Here are some of the key points from the story above. Some were explicitly stated, others were implied. But I’m listing them all here so you can have them all in one place and refer to them.
- Start with a trending stock. This makes your life so much easier, because the ideal scenario for covered calls is when a stock is gently rising and you’re constantly selling covered calls that expire worthless.
After a couple of rounds of this, you’ve lowered your cost basis so much that when you finally get called out, it’s a huge windfall. (make sure to read part 2 of this covered calls series to see the PLTR example!)
- Sell covered calls 7-10% above the current price of the stock.
- And 30-45 days till expiration
- VERY IMPORTANT: Never sell an option with a strike price below your cost basis. I understand this is tempting, because the closer you get to the price of the stock, the more premium you collect. But if you get called out below your cost basis, you just booked a loser. And that’s the exact opposite of what we’re trying to do. (as you get more advanced, you can do this and just buy it back if it moves against you, but to start out I highly recommend against this method)
- Earnings brings volatility – This means that the premiums you can collect when you hold an option over earnings are higher, which is good.
- As long as you do this strategy right, there’s a low probability of losing money. Of course, there’s always the possibility that a company goes out of business. But that is fortunately rare.
- The 7-10% and 30-45 days rules are not set in stone. You can always look and see what options are giving you the best premium for your goals.
- Some people think that if you get a stock “called away” from you, that you somehow lost. This is NOT true. If you are following the rules above and NEVER selling strike prices below your cost basis, you cannot ever sell at a loss.
- It is true, though, that if you sell a $150 strike price call and the stock suddenly goes to $175, you will not profit on gain above $150. But those situations are so rare it’s not even worth worrying about.
- The consistency of bringing in premiums regularly more than makes up for those once-in-a-blue-moon “pops” that you might miss out on.
UPDATE: I wrote a part 2 for this Covered Calls series where I used an example of PLTR during the same October 2023 – March 2024 timeframe.
And guess what? In this “best case scenario” example, we were able to pick up 80% returns by the time we would have been called out. Check it out here!
Trade well,
Jack Carter
