Covered calls are one of the most popular options trading strategies for new investors due to the low level of risk and lack of any additional margin or buying power requirements. However, when it comes to covered calls, there are three things traders should always look out for to avoid landing in hot water.
1) Selling Covered Calls Too Close to the Money
For every 100 shares of stock, investors can sell one call option. Since options always represent 100 shares, this ratio of contracts to stock never changes.
With that said, besides time until expiration (more on that later), the only other variable a covered call writer can decide is the strike price; the number of options a trader can sell depends entirely on the number of shares the trader owns. The “strike price” is the price at which the call options are sold, and the “spot price” is the price at which the underlying security trades.
One of the most common errors with covered calls is selling the call option too close to the money, i.e. the strike price is too close to the spot price. When this happens, it is far more likely for the stock to be “called away” from the trader at expiration, because the spot price has a much shorter distance it has to travel before passing the strike price. If the spot price passes the strike price at expiration, the short call options will be in the money and result in a short sale of 100 shares of stock per option contract. This will be offset by the existing long stock position and the entire trade will be profitable, but the long stock will be taken away from the trader’s account.
Ultimately, this is not the goal of selling covered calls. For example, say a trader owns 1,000 shares of stock XYZ that is currently trading at $50 and the trader sells to open the $51 call options for $0.50 and collects $500 in premium up front. The sale of the $51 XYZ call options will be fully covered, since the trader owns 1,000 shares of XYZ stock.
However, if XYZ trades up just $1.00 at the time the call options are set to expire, the entire position will be called away. Even though the trade will result in a profit of $1,500 (minus commissions), the best-case-scenario would be when the calls expire worthless and the trader still gets to hang on to the 1,000 shares.
As such, it behooves covered call traders to look to sell calls that are not too close to the spot price. Instead, look at selling calls that are further out of the money and have a much lower delta, and therefore, a much lower probability of expiring in the money.
2) Forgetting to Close Short Calls if the Value is at or Near Zero
Similar to selling covered calls too close to the money, forgetting to close out a profitable covered call position is a very common mistake. When a short option’s value has fallen to a near-zero level, it has reached its max-profit potential; covered call traders should never forget this.
It is impossible for a short option that has lost all of its value to make a covered call seller any more money, because all of the value has already been extracted. Whenever this is the case, covered call traders should always close out the short call options. Not closing out short covered calls with a value of zero is analogous hanging on to a short stock position that has fallen to zero; only bad things can happen.
Closing out valueless short options will lock in a profit and protect against any losses due to a volatility or underlying price increase.
3) Buying Shares of a Stock Just to Sell Covered Calls
Last but not least, buying shares of a stock just to be able to sell covered calls is unequivocally a situation that will land traders in ultra-hot water.
Although it may be appealing to sell calls on stocks that have high levels of implied volatility, because more option premium can be collected, often times these stocks are expected to move either up or down dramatically; and this stock price movement can cause significant losses.
A perfect example of this classic covered call mistake is buying shares of a volatile stock, like a biotechnology company, solely to be able to sell call options. The call options won’t be naked, but the underlying long stock position could prove to be very dangerous.
Perhaps the biotechnology company gets denied FDA approval for a new drug or doesn’t pass a clinical trial phase. Those juicy call options that the trader already shorted will be worthless, which is great, but the stock price will also plummet, which is very much not great. Although selling the calls will make up for some of the losses from holding the stock, it won’t make up for it entirely.
Selling call options is a bearish investment decision, buy buying stock is not. It’s never wise to buy shares in a company solely for the purpose of collecting call option premium.
Without question, these are three of the most common covered call trading mistakes, and being aware of them can help you avoid losses and become a much more savvy options trader.
Authored by Kevin @ OptionsBro