Covered Calls are the Trading Cheat Code | How to Trade Covered Calls

Summary

This video explains the concept of a covered call strategy in stock trading, where you sell a call option against shares you already own. It details how to implement the strategy, using an example with AMD shares, and describes the potential outcomes: the call expiring out-of-the-money or being exercised in-the-money. The video covers the pros and cons of covered calls, such as generating premium income and limiting downside risk, while also missing out on potential gains if the stock price rises significantly. The presenter also demonstrates how to execute the trade on the ThinkOrSwim platform, offering real-life application of the concept.

Takeaways

• 😀 A covered call involves owning 100 shares of a stock and selling a call option against it, generating extra income through the premium received.
• 😀 The premium received from selling the call is yours to keep, and it can reduce the effective cost of your shares.
• 😀 If the stock price stays below the strike price, the call expires worthless, and you keep both the premium and the shares.
• 😀 If the stock price exceeds the strike price, the buyer may exercise the option, forcing you to sell the shares at the strike price, limiting your profit potential.
• 😀 Selling a covered call allows you to generate income from stocks you already own, making it a good strategy for long-term holders.
• 😀 The downside of covered calls occurs if the stock price falls significantly, though the premium collected can offset some losses.
• 😀 Choosing the right strike price depends on how much premium you want to collect and how comfortable you are with selling your shares at that price.
• 😀 Covered calls are a conservative strategy best suited for investors who are okay with possibly having to sell their shares at a predefined price.
• 😀 If you sell a call option that expires out of the money, you get to keep the premium and your shares without any further obligations.
• 😀 The biggest risk with covered calls is missing out on further stock price appreciation if it rises significantly above the strike price.
• 😀 In scenarios where the stock price declines, the premium received from the covered call reduces the overall loss, offering some protection.

Q & A

What is a covered call in stock trading?

A covered call is an options strategy where an investor who owns 100 shares of a stock sells a call option against those shares. This generates income in the form of a premium, but the investor may have to sell their shares if the call option is exercised.

What happens when you sell a call option against stocks you own?

When you sell a call option, you're agreeing to sell your 100 shares at a specific price (the strike price) if the buyer exercises the option. In return, you receive a premium upfront, which you get to keep regardless of the outcome.

What are the two possible outcomes when you sell a covered call?

The two possible outcomes are: (1) the call option expires out of the money, and you keep your shares and the premium, or (2) the option expires in the money, and your shares are sold at the strike price, but you still keep the premium.

How does selling a covered call reduce your cost basis?

By selling a covered call, you receive a premium that you can subtract from the original price you paid for the shares. This reduces the cost basis of your position, making your shares effectively cheaper.

What are the risks involved in selling a covered call?

The main risk is missing out on potential gains if the stock price rises significantly above the strike price, since you'll be required to sell your shares at the strike price, even if the stock's market value is higher.

Why is it important to be comfortable selling your shares at the strike price when using covered calls?

It's important because if the stock price rises above the strike price, you’ll have to sell your shares at the strike price, which might be lower than the market price. You should be okay with this outcome before entering the trade.

What happens if the stock price falls while you have a covered call position?

If the stock price falls, you will experience losses on the shares you own, but the premium you received from selling the call option can help offset those losses, reducing your overall cost basis.

How does the strike price of the call option influence the premium you receive?

The closer the strike price is to the current stock price (or the more likely the option is to be exercised), the higher the premium you can receive. Out-of-the-money calls have lower premiums because they are less likely to be exercised.

Can you lose money with a covered call strategy?

Yes, if the stock price falls significantly, you can lose money, even though you’ve received a premium from selling the call. However, the premium can help reduce your overall losses.

What is the benefit of using a trading platform like Thinkorswim for covered call strategies?

Thinkorswim provides advanced features such as on-demand trading, allowing users to simulate trades and analyze past market data. This helps traders better understand how covered calls work and make more informed decisions.