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Covered Call Strategy Explained

by | Feb 23, 2019 | Bishop's Corner

Before I share with you this case study, yesterday’s earnings winner ($14K+), an options trade in the Trade Desk (TTD)…  I’d like to thank you for taking the time out of your weekend to study, learn, and become a better trader.

That said, we’re all running our own race here. Learning how to trade options is not easy, but I’ll try help and cut the learning curve in half. If you any of this sounds fuzzy, it’s okay, be patient and stay diligent.

I promise you, these skills are worth learning.

(I teach my clients how to trade using real money. I stream my trading account in real-time and alerted my moves in real-time via text and email.)

That said, the beauty of options trading is that it lets you take advantage of opportunities that are not offered when you trade stocks.

For example, when you are trading stocks you can make money by going long or short… that’s it. However, with options you can make bets on where a stock WON’T GO.

And that’s part of the premise of today’s case study. An earnings trade involving the Trade Desk (TTD). The strategy I used is called a “covered call” … It involves a combination of  stocks and options

That said, it’s a “mildly” bullish strategy. In other words, the strategy says, “I think the stock is going to go up, but not by much. I also don’t think there is much downside risk.”

Covered Call Strategy Explained

Now, if you’re still wondering why anyone would want to run a covered call strategy, it’s simple. Basically, your outlook is neutral to bullish, and you’re willing to sell your shares when it reaches a specific price (the strike price).

Options traders will use the covered call strategy, also known as a buy-write strategy, when:

  • They’re long stock and have already seen some unrealized profits. They would sell out-of-the-money call options, so if the stock goes up, they’re willing to take profits at the specified strike price. Conversely, if the stock pulls back, they would receive the premium.
  • They want to lower the cost basis of their position.
  • They don’t feel comfortable paying a hefty premium to be long call options ahead of a catalyst event.

The setup here is:

  • Long stock
  • Short call with a strike price above the current stock price

Now, here’s a look at the profit and loss (PnL) diagram, also known as the risk profile, on the expiration date.

As you can see, the upside is limited here. However, selling the call helps to minimize downside risk.

So let’s say you like a stock, but still want to be long it after a catalyst event. If the stock goes up, you get to participate in the upside. On the other hand, if the stock goes down, you would actually collect the premium of the short call, and essentially you would “own” the stock at a lower price.

Covered Call Strategy Maximum Profit Potential.

Now, the maximum profit potential of the covered call strategy is limited to the strike price less the stock price plus the premium received for selling the call option. For example, if you’re long 100 shares of a stock at $100, and sell 1 call option on that stock with a strike price of $110 for $5, your maximum profit would be $1,500 ($110 – $100 + $5)*100. Keep in mind, stock options have a multiplier of 100.

But when is your maximum profit potential reached?

Well, it depends on your goals. If you use the strategy to just earn income, you want the stock price to be as close to the strike price as possible. However, you wouldn’t want the stock price to break above the strike price.

On the other hand, if you want to just sell your shares while making some side money by selling the calls… then you want the stock price to rise above the strike price and stay around there at expiration. Consequently, when those options expire in the money, your calls would be assigned and you would be flat the position.

In general, you probably don’t want to see the stock explode way above the strike price because you would be disappointed if the stock went up 30%… and you might have the fear of missing out (FOMO) and revenge trade. That said, if you’re running this strategy, you should manage your expectations properly… even if the stock goes a lot higher, it’s thinking in hindsight. This is Weekly Money Multiplier… not Hindsight Capital.

Moving on.

Break-Even Point

Your breakeven PnL on the expiration date would be equivalent to the stock price less the premium received for writing the call option.

What’s your maximum loss though?

Covered Call Strategy Maximum Loss

Now, since this strategy involves writing a call option, you minimize your downside risk. Most of the downside risk stems from owning shares of the stock. That said, theoretically, your maximum loss would be the price at which you own the stock less the premium. For example, if you own 100 shares of a stock at $20, and receive $500 ($5*100) in premium for selling 1 call option contract, your maximum loss would be $1,500… that’s if the stock goes to $0. However, it’s very rare to see a stock lose all its value that quick.

That said, let’s take a look at an example of the covered call strategy.

Covered Call Strategy Trade Example

A lot of Weekly Money Multiplier clients have been asking me about my earnings ideas. Now, before you go out and start trading earnings, you need to fully understand options trading – especially implied volatility.

Now, one of my earnings ideas was The Trade Desk (TTD) – one of my favorite stocks now. It had a nice down day ahead of earnings. When I was looking at the options, they looked very expensive, and the market was expecting a 14% move for TTD in either direction.

I don’t like the idea of buying shares of the stock ahead of earnings, buying options outright, or selling options naked. Those are all risky strategies ahead of earnings. Moreover, just because the market expects a 14% move… it doesn’t mean the stock will move exactly 14%.

To gain exposure to TTD ahead of earnings, I placed a small bet on covered calls in TTD. The first thing I had to do was set up the stock position. So I bought shares in the $148 area. Since I owned the stock and didn’t want to hold shares without minimizing some of my risk, I sold some call options against my shares.

If you look at the hourly chart below, you’ll notice a blue horizontal line. This was a previous breakout area, and I figured it would make sense to sell $160 call options expiring the week of its earnings.

Now, I was able to sell those options for $6. Remember, equity options have a multiplier of 100.

What I was Thinking in the TTD Covered Call Strategy

Therefore, if the stock went up to $166, I would participate in the up move. If the stock went to $200, you wouldn’t make any profits above $166. However, based on my covered call position… that would be a 10% move in a day… and I’d be happy to take that any day.

My risk here is the options get assigned and I would be forced to sell my shares at $160 (depending on how many contracts I sold). This is due to the fact that I sold them the right to buy my shares at $160 on or before the expiration date. So if TTD got to $175… those who bought the calls would exercise their right to buy TTD for $160 and sell those shares at $175 to collect $9 ($175 – $160 – $6 (the premium they paid)).

Here’s what the stock did after earnings.

I made my maximum profit potential of around $14K.

Could I have made more?

Yes… if I had just bought call options outright. But that could’ve been dangerous if the stock didn’t have a move like that. Think if I bought 25 call option contracts for $6 a piece… I would’ve spent $15,000 (25 * 100 * $6). What happens if TTD actually cut their guidance and sold off… that $15K would’ve evaporated into thin air.

It looks easy after the fact… but when you’re in the heat of the moment, and the options market is telling you the stock could move 14% in either direction… and you see some resistance at the blue horizontal line… it’s a lot harder to just outright buy call options or stock.

That said, the covered call is a conservative strategy. But if you’re looking for more excitement then you should check out what Jeff Williams and Davis Martin have cooking up. Recently, Jeff was able to take three separate trading accounts and return 200%, 220%, and 600%

And you know what?

He had zero losing trading days last month. Anyways, here is the registration link to a live event that they’ll be hosting on Tuesday, February 26, 2019. As a student of the market you know I’ll be attending and taking notes. See you there.

Bishop Recommends

“Never lose more than 2% of your entire account on any trade.”

That’s just one of the golden rules that has helped Petra Hess amass millions in trading profits.

She teaches her risk-averserules-based, and consistently-profitable strategy to new stock traders.

Join her latest webinar as she explains how to time your entries and exits.

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