The basic strategy is simple, buy 100 shares of stock and sell one call on that same stock. The strategy is easy but there are a lot of things to think about.
First, the good news. You can make a lot of money from covered calls and actually reduce your risk. High reward, low risk! Awesome!
The best thing is to find a stock in a bull market. Covered calls are a bullish strategy so we want to have the underlying stock be in a bull market.
Technically, we could use a stock in a sideways market but we will have greater profits and less risk if we use only stocks in bull markets.
The second thing to do is to find an option that is at the money and going to expire in the next month.
We want at the money because at the money options have the highest time premium and the profit in the trade is really the time premium. We may get some profit from the stock going up but I always assume that the profit will come from the time premium going to zero.
We want an option that expires soon. Preferably less than a month. Heck, expiring in the next week is great! The reason is that the option will have the highest amount of time decay in the last month of trading with the time decay accelerating as we get closer and closer to expiration. Our profit per day keeps going up as we get closer to expiration.
We need to protect ourselves against a decline in the price of the stock because that is our risk.
So find a great spot to put a stop loss. Look at the chart of the stock. Where is the best place to put a stop loss? Is there an obvious place to put a stop loss? Is there a place with a lot of support? That should be the place you want to put the stop loss on the stock.
What if the ideal stop loss is a long way below the current price action? What if you would have a large loss if you put the stop loss way down there? This is usually not the case but you will have to find a weaker stop loss that is closer to the pricer action.
You don’t want to pick an arbitrary place to put the stop loss, like the break even point. That actually increases the chance of a stop out.
But sometimes you don’t have a choice if the ideal stop loss is far away. You might have to find a weaker level of support. Not ideal but sometimes we have to compromise.
Now comes an interesting aspect of a covered call. You have put the stop loss in the market. Let’s assume that the stock price falls and you are stopped out of the stock. You still have the short call. My strategy is to keep the short call and hopefully let it expire worthless. That’s going to happen over 90% of the time.
But you need to get out of the short call quickly if the stock starts to rebound.
The great thing about covered calls is that they actually should outperform the market with less risk than the market!
I aim for a 60% return each year but with less risk than the stock market! Sweet!
I can help you make money in covered calls in three ways:
- Subscribe to my amazing new Options Navigator program. You actually get to see my real trades every day, including my covered call trades!
- Download our free Option Strategy Guide. This is a free PDF download that shows all the main strategies including covered calls. It’s like having a cheat sheet at your elbow when you trade. It really simplifies option trading. You can get it here for free by clicking here.
- Are you new to options trading? Then you should look at the Options University Options 101 class. You can learn more by clicking here.
Good covered call trading!