Market Basics

Overview

Stock trading gives investors the opportunity to own a small piece of a company. You can buy shares in some of the most incredibly diverse and innovative companies from all over the world. Some stock traders are passive, holding positions for long periods of time, gaining profits if the stock price increases, but suffering losses if the stock price decreases. Other traders take a more active role in managing their stock positions, by writing (selling) call options against their stock positions (Covered Call Writing).

With ‘Covered Call’ writing, you can leverage your stock positions to generate additional returns, reduce the cost basis of the stock, and reduce your downside price risk. Writing covered calls is a basic options strategy, but as with all investments, there are both potential risks and benefits which need to be understood before you decide to engage in this strategy.

Why Trade Covered Calls?

Writing covered calls may be an excellent way to enhance the overall return on you stock position. Writing covered calls is considered a limited risk options strategy, where the stock you own covers the upside risk of writing the call options, which, if written alone (naked) has an unlimited loss potential. Since one options contract represents 100 shares of stock, you can write one call option for every 100 shares of stock that you own.

By selecting an appropriate strike price and expiration date for the call option you want to write, you can take advantage of the time value decay as the option nears expiration. The goal is to have the option be worth less at expiration than when you wrote it, preferably expiring worthless.

When you write a covered call, you collect the option premium, and that premium effectively reduces the cost basis for the stock, giving you some added downside risk protection for the stock. You are then obligated to comply with the terms of the option.

Covered Call example – Collecting Premium
You currently hold 100 shares of XYZ stock with a cost basis of $80.00 per share. Currently, XYZ is still trading at $80 per share. You decide to write one covered call option with a strike price of 85 that is expiring in 22 days and collect a premium of $2.50 per share or $250. This premium effectively reduces your stock cost basis to $77.50 per share.

One other benefit to consider here is that writing covered calls allows you to continue to collect the dividend on the stock you own, as long as you own the stock prior to the ex-dividend date.

Volatility Risk

Covered Calls benefit from falling volatility.

Volatility risk comes in several forms. The first form is the implied volatility derived from the option price itself. As volatility rises, the price of long call and put options rise as well. Writing options in a rising volatility environment – like going into earnings – can work against the covered call writer. Remember, generally you want to try and buy low volatility options and write high volatility options, so your position may benefit from volatility return to its mean.

TradeStation offers historical implied volatility for all optionable stocks so that you can compare the current volatility to historical norms. See Figure One.

Figure One: A daily chart of AMD with the “Implied Volatility All Options” indicator.

You can learn about TradeStation’s volatility tools here:
www.youtube.com/watch?v=sCQuoJpJOfY

Option price volatility can also be affected by options with low volume (low liquidity), making it difficult or expensive to exit a position. Also, certain stock sectors that can be very speculative, like biotech, may offer higher covered call returns, but the downside stock risk can be significant.

Pin Risk or Expiration Risk

Pin risk, also called expiration risk, is the risk of uncertainty as to what position will be remaining after expiration. A covered call writer has ‘Pin Risk’ that the option they wrote will expire slightly in the money just before market close on expiration Friday, thus ‘pinning’ them in a position of uncertainty until the market opens again. The biggest risk here is assignment risk and having the stock called away. If you don’t want to take the chance of assignment and have your stock called away, you can always close the covered call write prior to market close on expiration day.

Conclusion

Covered call writing can be a good way to learn more about options trading and all the moving pieces you need to consider prior to engaging in more speculative trading options. Here are three best-practices guidelines all new options traders should consider:

1. Select the appropriate stock price and expiration date.
   Start out by hitting singles – small, short winning trades that help build your experience and confidence. This means selecting the appropriate strike price and expiration date. You may want to start with a slightly out-of-the-money strike price with less than three weeks until the expiration date. Make a few trades like this, review the results, continue learning, and adjust as needed.
2. Stay alert to what is going on in the market.
   Always know what is going on with the stocks you are holding; when is the next earnings announcement date, does the stock pay a dividend, when is that next ex-dividend date, is there market news that can adversely affect my position. Keeping your head in the game and on top of all the factors that can affect your options positions will help you avoid adverse surprises.
3. When things go wrong, have a plan.
   All traders experience losing trades. It is often the trades we do not plan out in advance that turn into the biggest losers. Determine how much money you are willing to risk on each trade before you enter that trade. Try to consistently risk a small percentage of your total account on each trade. And do not expect to make up losing trades with one big winner.

If you are new to options trading, find a mentor who is trading with real dollars, and follow their trades and methodology. And although options trading is not suitable for everyone, you will not really know until you try.