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what's going on everybody Chris here
from Project option and welcome to the
newest options trading strategies video
so in this video we're going to talk
about the bullish strategy of the
covered call now a covered call is a
very common strategy among long stock
investors because it's a strategy that
allows you to collect premium without
adding any risk to your long stock
position so let's get into it so let's
take a look at the covered call strategy
characteristics so covered call writing
is a strategy that consists of selling a
call option against a hundred shares of
long stock now the strategy is common
among long-term investors who wish to
enhance their yield on shares of stocks
that they already owned
now that's because selling a call
against 100 shares of stock actually
gives you some downside protection and
actually allows you to profit if the
stock remains flat over a certain period
now those luxuries come at the cost of
capping the upside profit potential on
those long shares so the maximum profit
potential of a covered call is the short
call strike price plus the call credit
you receive minus the share purchase
price times 100 so there's a lot going
on there but do not worry we're going to
go through in-depth examples so that you
understand each of these characteristics
so the maximum loss potential is the
share purchase price minus the call
credit times 100 so you can see that
collecting a credit from selling a call
actually reduces your maximum loss
potential because if you didn't collect
any premium your maximum loss on your
shares is just the amount you pay for
the shares times 100 so for the
expiration breakeven price it's going to
be the share purchase price minus the
call credit you receive now the
estimated probability of profit for any
covered call strategy is greater than
50% because since you're collecting a
premium from the call and that's
actually adding some downside protection
which means your shares of stock can
actually decrease in price a little bit
and you can
still not lose money so for that reason
the probability of profit for a cover
call is higher than 50% now after
expiration if the short call is in the
money a covered call trader will
essentially have their shares calls away
now that's because a short call
assignment results in you selling 100
shares of stock at the college strike
price so since you already own 100
shares of stock if you're assigned on
the short call you'll effectively sell
your shares of stock at the short call
strike price now since the short call or
a cover call includes a short option in
the strategy you do have assignment risk
if the short call is in the money before
expiration as you can be assigned early
on that short call all right so let's
take a look at a covered call example
trade and basically run through all of
those characteristics that we just
talked about in regards to a real
example so here we see different strike
prices and the prices of the calls
associated with those strikes now let's
say at the time of these option prices
let's say the stock price is trading for
$75 so to construct a covered call we'll
buy a hundred shares of stock for $75 a
share and we'll sell one of the 80 calls
for $3 in premium so we're buying 100
shares of stock at $75 we're selling the
80 call and we're collecting a $3.00
premium from selling that call so let's
go ahead and take a look at the
expiration risk graph for this
particular covered call position alright
so let's take a look at this profit and
loss graph so the dark line there
represents the profit and loss of the
covered call position at each stock
price at expiration the gray dashed line
represents the profit and loss of just
the long stock position of a hundred
shares the green dashed line represents
the covered calls breakeven price and
the red line represents the short calls
strike price so what I want you to
notice here is that at any stock price
below $80 the covered call position is
going to perform better than the long
stock position because we collected
premium from that short call so for
example if the stock price falls to
sixty-five dollars the profit and loss
on the long stock position is going to
be negative one thousand dollars that's
because if we buy stock at $75 and it's
worth sixty five dollars we have a ten
dollar loss per share
and since we're long a hundred shares of
stock the loss is a thousand dollars now
however we can see that the covered call
position is not down a thousand dollars
at $65 now that's because we collected a
three dollar premium from the ad call
option which means at $65 the covered
call is going to be down only $700
because we're going to be down a
thousand dollars in the long stock
position but we're going to have a $300
profit on the short ad call so that
short call provides a little downside
protection when the stock price Falls
now as you'll notice the break-even
price of the covered call is actually 72
dollars even though we bought shares at
75 dollars a share that's because we
bought 100 shares of stock for $75 per
share and we collected a $3 premium per
week of a $3 premium for selling the 80
call option so selling that call option
gives us a little bit of downside room
now when the stock price is trading for
$80 we're going to have a profit of $800
on the covered call position and only
$500 on the long stock position so if
the stock price is right at our short
call strike we're going to have a $5
profit per share plus a three dollar
profit from the short call option and if
we multiply both those figures by a
hundred we get 500 dollars of profit on
the long stock and $300 a profit on the
short call option so at $80 they short
call will expire worthless and we'll
have a profit on both positions now at
any price above $80 we can see that the
covered calls profit is capped at $800
now that's because at any price above
$80 that that short ad call is going to
cap our profits on the long stock
position and we're not going to be able
to make any more money so for example if
the stock price goes to $90 we're going
to have a fifteen dollar profit per
share on our
long stock but we're going to have a $7
loss on our short call position because
that that 80 call is going to be worth
$10 and we sold it for $3 which means
we're going to have a loss of seven
dollars so the $15 gain on the shares -
a $7 loss on the short call brings us to
a net profit of $8 times 100 gives us a
net profit of $800
so at any stock price above $80 which is
our short column strike price our profit
will be the same so that's the real risk
of a covered call is that the stock
price explodes to a price higher than
your short call strike and you miss out
on those gains because by selling the
call option you've agreed to cap your
upside alright so let's go ahead and
take a look at a couple example trades
so that you can see how I covered called
performs relative to a long stock
position so here's the setup of the
first example trade the initial stock
purchase price is 121 dollars and 45
cents and we're going to look at selling
the 125 call that expires in 74 days now
we're going to collect one dollar and
forty one cents for selling that 125
call which means our breakeven price on
this covered call strategy is one
hundred and twenty one dollars and
forty-five cents - the credit received
from the call of one dollar and forty
one cents and that brings our breakeven
stock price to one hundred and twenty
dollars and four cents now our maximum
profit potential in this case is the
strike price of 125 less our effective
share purchase price which is
essentially the same thing as the
break-even price so 125 - 1 2004 gives
us a maximum profit potential of 496
dollars so our maximum loss potential is
the effective share purchase price which
is the break-even stock price of a
hundred and twenty dollars and four
cents times 100 which brings our maximum
loss potential to 12 thousand four
dollars now that maximum loss potential
only occurs if the stock price Falls to
zero in the next 74 days so that's a
very rare scenario but it is worth a
mention because it can happen so let's
go ahead and take a look
how this covered call position performed
through time so at the top of this graph
we're looking at the stock price changes
and we're looking at the stock price
relative to the short column strike
price and the covered calls break-even
price and in the bottom of the graph
we're looking at the profit and loss of
the long stock position by itself and
the covered call position which includes
the long stock position and the short
call so as we can see here the stock
price just ripped right through the
short call strike price and trade it all
the way up to around 135 dollars and
stayed above the short call strike price
through expiration now if we look at the
profit and loss of the two different
strategies we can see that the the long
stock position has no cap to the amount
of profit that it has but going into the
covered call position we know that the
maximum profit is 496 dollars so as we
can see here when the stock price
exploded our covered call positions
profits were capped right around 500
dollars because there's only so much you
can make when you have a covered call
position so this is an example of how if
the stock price explodes the long stock
position by itself will do better than a
covered call
alright so example number two we're
going to look at a covered call position
that produces profits when the stock
price remains flat and doesn't really go
anywhere so here's the setup
the initial stock purchase price is 116
dollars and 45 cents and we're going to
look at selling the 120 call that
expires in 53 days so we're going to
collect five dollars and 80 cents of
premium from that short 120 call which
brings our breakeven stock price to 116
45 minus five dollars and 80 cents
which brings our breakeven price to 110
65 now our maximum profit potential is
this short call strike price of 120
minus the effective purchase price of
the shares of 110 65 times 100 which
brings our max profit to 935 dollars now
our maximum loss potential is the
effective share purchase price of 110 65
times 100 which is 11,000 11,000 and $65
now that max loss potential only occurs
if the stock price Falls to $0 so let's
go ahead and take a look at how this
covered call performs through time
all right so in the top of the graph
we're looking at the stock price the
short call strike price and the covered
calls breakeven price and on the bottom
part of the graph we're looking at the
profit and loss of the long stock
position and the covered call position
so what I want you to notice here is
that the stock price is you know if the
stock price is relatively flat over this
entire period and it pretty much trades
between the short call strike price of
120 and the break-even price of 110 65
now when you look at the profit and loss
of the two strategies we can see that
the covered call position is performing
better than the long stock position
pretty much the entire period and that's
because the covered call position has
steady profits from the decay of this
short call option that were that we sold
so this is just showing you that when
the stock price remains flat a covered
call position will perform better than a
long stock position because the covered
call can profit from the short call now
at expiration we can see that the stock
price is between the short call strike
price and the breakeven price so it was
profitable overall however the long
stock position by itself came out short
with you know a profit of $0 because the
long shares ended at the same exact
price that they began at so if you just
bought shares in this case you didn't
make any money but if you would have
sold a call option against your shares
that premium actually led to profits
overall at the end of the period so in
fact since we collected 5 dollars and 80
cents for selling that call option the
profit and loss was around 580 dollars
at expiration
while the profit and loss on the long
shares was zero dollars so this shows
you how you can make money with a
covered call if the stock price remains
relatively flat or even decreases it a
little bit over the period
all right so let's look at example
number three which is a defensive cover
call so let's take a look at a covered
call that is implemented in a defensive
manner now a defensive cover call
basically means that you're selling a
call option against shares of stock
because you believe that the stock price
might fall slightly in the near future
and selling a call against your stock
will give you a lower breakeven price
and some downside buffer so here's the
setup
so the initial stock purchase price is
$119.99 and we're going to look at
selling the at-the-money 120 call that
expires in 37 days now for selling that
120 call we're going to collect a
premium of two dollars and 58 cents
brings our breakeven stock price to one
1999 - 258 which is one 1741 now our
maximum profit potential on this trade
is 120 which is the short called strike
price - one 1741 which is the effective
share purchase price times 100 which
gives us a max profit of two hundred and
fifty nine dollars now the maximum loss
potential is the effective share
purchase price of 117 41 times 100 which
is eleven thousand seven hundred and
forty-one dollars now again that max
loss only occurs if the stock price
Falls to zero which essentially means
the company just went out of business so
it's a very unlikely scenario especially
if you're trading cover calls on blue
chip stocks or stocks with very solid
companies around them alright so in the
top part of the graph again we're
looking at the stock price the short
college strike price and the covered
calls breakeven price and in the bottom
part of the graph we're looking at the
profit and loss of the long stock
position and the covered call position
separately so as you can see here right
off the bat the stock price rallied a
little bit to 120 250 but then fell down
all the way to a hundred and ten dollars
per share now if we look at the covered
call profit and loss relative to the
long stock profit loss when the stock
price fell to 110 the long stock
position was down about a thousand
dollars however the covered call
position was only down $750
because as the stock price decreases
that short call is going to decrease in
value as well so by selling that call
option we actually have profits coming
in from that short call that offset our
losses on the long stock position so we
compared the covered call in the long
stock PL over this entire period we can
see that the covered call performs
better than the long stock position the
entire time and that's them entirely
from the premium that we collected from
selling the call option so if I recall
correctly we collected about two dollars
and fifty cents from that call option
and as you can see the covered call
performs about two hundred and fifty
dollars better than the long stock
position over this entire period so this
just goes to show that if you're if
you're in a defensive state and you want
to you know I had some downside
protection to your long shares one thing
you can do is you can sell a call option
against your shares and that will
provide some downside protection should
the stock price decrease
all right so now that we've talked about
covert calls you may be wondering how do
you select a call strike to sell well it
all depends on your outlook for the
stock and there really is no one right
answer so let's go through some
guidelines and see if we can figure out
how you can determine which college
strike to sell based on your stock price
outlook so first of all let's say you
think the stock price will increase
significantly well my answer to this is
if you have such a bullish outlook it
may not make sense to sell a call
against your shares because doing so
caps your upside potential when the
share prices increase so the stock price
surges in value you don't want to be
sure to call you don't want to have a
covered call because that's going to
limit your profitability on the upside
so if you're extremely bullish on the
stock it may not make sense to sell a
call against it at all maybe you just
hold along shares now if you think the
stock price will increase slightly but
not significantly you may be able to
sell a call with a 25 or 35 Delta so a
significant stock price increase could
be defined as a one standard deviation
move which is wherever the 16 Delta call
is so if you think the stock price could
is not going to move to the 16 Delta
call maybe you sell the 25 or 35 Delta
call now let's say you think the stock
price will remain relatively flat and
you want more protection by selling a
covered call so in this case if you want
downside protection you may want to sell
a call with a delta of 40 to 50 because
that's going to provide you the greatest
profit potential from extrinsic value
and that's also going to give you the
greatest credit and therefore provide
you with the greatest downside
protection now let's say you think the
share price will fall significantly well
with such a bearish outlook it may not
make sense to be trading a covered call
at all because a cover call is a bullish
strategy and if you think the stock
price is going to fall you're actually
bearish so the cover call does not make
sense in that scenario
all right so let's recap the main
concepts from this video so covered call
writing is a bullish strategy that
consists of selling a call against a
hundred shares of stock cover callers
have limited profit potential but a
higher probability of profit than simply
buying shares
additionally the premium received from
the call provides some downside
protection to close a covered call
before expiration the long shares can be
sold in the short call can can be bought
back at its current price to lock in
profits or losses now this can be done
in one transaction now on a stock that
remains relatively flat a covered call
position will outperform just buying and
holding shares because as we've as we've
examined in some of the examples when
you put on a covered call you're
actually collecting premium from that
short call which can be a profit driver
if the stock remains flat or even
decreases slightly and lastly if the
short call is in the money a covered
call trader faces early assignment on
the short call which will result in the
long shares being sold at the short
calls strike price so if you are signed
in your short call you're effectively
just selling your shares at the strike
price of the call but you're also going
to keep the premium that you sold so
it's not such a bad thing after all
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