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Covered Call Options Strategy

Overview

DEFINITION

A covered call is a common strategy that is used to enhance a long stock position. The position limits the profit potential of a long stock position by selling a call option against the shares. This adds no risk to the position and reduces the cost basis of the shares over time.

DIRECTIONAL ASSUMPTION

Bullish

IDEAL IMPLIED VOLATILITY ENVIRONMENT

High

PROFIT/LOSS CHART

Profit loss chart of a Covered Call

SETUP

Buy 100 shares of stock

Sell 1 ATM or OTM call for every 100 shares

HOW TO CALCULATE MAX PROFIT / BREAKEVEN(S)

MAX PROFIT

Distance Between Stock Purchase Price & Short Call + Credit Received

BREAKEVEN(S)

Stock Purchase Price - Credit Received

tastytrade approach

We almost always prefer covered calls to naked stock because it allows us to profit when the stock doesn’t move at all, and it also reduces our max loss if the stock goes down. It’s important to consider the credit received from the call when deploying this strategy. If we can only collect $0.10 by selling the call, we may consider another strategy or hold off on selling the call until we can find more premium.

We look to deploy this bullish strategy in low priced stocks with high volatility. Based on our studies, entering this trade with roughly 45 days to expiration is ideal. We typically sell the call that has the most liquidity near the 30 delta level, as that gives us a high probability trade while also giving us profitability to the upside if the stock moves in our favor.

CLOSE / MANAGE

WHEN TO CLOSE

We close covered calls when the stock price has gone well past our short call, as that usually yields close to max profit. We may also consider closing a covered call if the stock price drops significantly and our assumption changes.

WHEN TO MANAGE

We roll a covered call when our assumption remains the same (that the price of the stock will continue to rise). We look to roll the short call when there is little to no extrinsic value left. For instance, if the stock price remains roughly the same as when we executed the trade, we can roll the short call by buying back our short option, and selling another call on the same strike in a further out expiration. We will also roll our call down if the stock price drops. This allows us to collect more premium, and reduce our max loss & breakeven point. We are always cognizant of our current breakeven point, and we do not roll our call down further than that. Doing so can lock in a loss if the stock price actually comes back up and leaves our call ITM.

Supplemental Content

Episodes on Covered Call

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