Covered call writers get paid cash when selling call options. Call buyers pay cash to own the options. This article will highlight the reasons options are bought and sold as it relates to covered call writing. We will use a real-life example with CarMax, Inc. (NYSE: KMX), a stock on our Premium Stock Report on October 30, 2019.
KMX option chain on October 30, 2019 with KMX priced at $95.35
KMX calculations with The Ellman Calculator
When the trade is executed, an initial 1-month time-value return of 2.5% is generated with an additional potential 0.7% of upside potential for a possible 3.2% 1-month return. Now, let’s look at this trade from buyers and sellers perspectives.
Option buyers have rights
The option buyer is now controlling 100 shares of KMX per-contract until the 11/29/2019 expiration at a cost of $240.00. The cost of buying 100 shares would be $9,535.00. The buyer has the right, but not the obligation, to buy 100 shares of KMX (per-contract) at $96.00. This makes the breakeven at $98.40. ($96.00 + $2.40). The buyer can:
- Sell the option
- Exercise the option (buy shares)
- Allow the option to expire worthless
Approximately 70% of options are closed, 20% expire worthless and 10% are exercised.
Option sellers have obligations
As option sellers, we are required to provide shares to the option buyers (if they choose to exercise the options) at the strike price and by the expiration. By first buying the shares, we are in a “covered” or protected position… we know our cost-basis. By undertaking this obligation, we are paid a cash premium. The seller can:
- Buy back (close) the short call (buy-to-close) and end the contract obligation
- Allow the contract to reach expiration to expire worthless (if strike ends out-of-the-money) or result in exercise (if the strike expires in-the-money)
Option buyers pay for the right to control shares of stock (or ETFs) at a relatively low cost. If they are directionally correct, there is an opportunity to generate impressive returns on the capital investment. Generally, this is a more aggressive approach to option trading than covered call writing.
Option sellers are paid to make shares available to call option buyers. We select the price we are willing to sell our shares for and the length of the contract duration. Generally, this is a more conservative approach to option trading.
Your generous testimonials
Over the years, the BCI community has been incredibly gracious by sending our BCI team email testimonials sharing stories as to what our educational content has meant to their families. Moving forward, we have decided to share some of these testimonials in our blog articles. We will never use a last name unless given permission:
Your Complete Encyclopedia is a gem and introduced me to the world of options from simple stock trading. I’m looking forward to a long-term association. I really love your passion and can relate to you as a self-taught in this interesting finance world.
1. Michigan AAII Chapter webinar
Trading in a Low Interest-Rate Environment
Creating a 3-income stream strategy
Wednesday June 24thth
Login information to be sent to registered members (club and premium members)
2. Greensboro North Carolina AAII Chapter webinar
Covered Call Writing to Generate Monthly Cash-Flow
Option Basics and Practical Application
Saturday June 20, 2020
Login information to be sent to registered members (club and premium members)
This presentation will include the basics of trading option, an overview of covered call writing and 4 practical applications of the strategy.
Market tone data is now located on page 1 of our premium member stock reports and page 8 of our mid-week ETF reports.
I greatly appreciate your advice. I wish I had followed your methodology of writing the calls at the time of the stock purchase.
I recently bought BMY 300 shares and plan to write the calls. Somehow the implied volatility is over 100% and the premium seems usually high. It seems to be related to “$5000.0 cash in lieu of shares, 100 shares of BMY, 100 shares of BMY/R”. Can you please advise?
Last year, Celgene merged with BMY and the options from a CELG perspective changed to a ticker beginning with “BMY1” These options reflected the merger agreements (cash + shares of BMY + certain product rights). There are some BMY1 options still available. If you own BMY and want to be “covered”, make sure you sell BMY, not BMY1 options. Then the returns should make sense.
You will not be “covered” if you sell BMY1 options.
I have watched a lot of your videos and take notes and learning covered calls. I subscribe to your channel and they are all very good.
Wish I was in the States to go to the Money Show to meet you. It will definitely inspire me to be a better trader.
I have been trading for 3 years, started learning with a company that specializes covered calls only. (not in the US).
You may be interested in how this company teach covered calls.
They give us a stock pick every day – like your weekly one. Since it is everyday, if they can’t find any good stock, there is no stock pick for the day. Sometimes they have a couple of picks a week, sometimes nothing at all for the week. They often pick stocks with the expiry date for 3 days to 14 days. When I started with them in 2017, they were monthly calls, now they do weeklies.
Unfortunately they don’t teach good exit strategies like you do. I am stuck with 4 positions for 18 months to 2 years with unrealized losses of over 33K of my small portfolio – devastating.
For example, I have AA, X, FL, and URBN which I chose from their stock picks. They are like 80% down from when I first purchased them.
How they teach to try to get out of positions are to write a call (typically for a week or less) when we are happy with technicals that the call would most likely to expire worthless.
That is often when stock hits a support, or break through resistance. They have online coaches for us to consult with, so what I have been doing is under the coaches guidance.
So we write a call and hope that it will expire worthless to collect small premium, to reduce break even.
Their strategy is that we have a conditional order attached to it – to buy back when the stock price reaches 5 cents below the strike price in the last week of expiry (10 cents below up to the last week of expiry, then change to 5 cents) Obviously we don’t want to be exercised for $8, when your purchased price is over $50. (like my AA)
Because of the conditional order – it gets triggered, often within a few minutes after the call order went through. It happened so many times so my BE are more than the original purchase price of the stock. I got really sick of this process, and stopped writing conditional orders.
AA BE is 54.32 Current Pricce 6.66
X BE 28.59 Current price 7.17
URBN BE 55.11 Current price 16.65
FL BE 55.11 x Current price 25.42
So basically, that is what the ‘coaches’ say to do, write a call with conditional order. ( and pray that the stock will go up in the future)
It hasn’t been working, as the stock price dropped so much( I am aware that March market crash didn’t help or isn’t helping) – the coaches didn’t teach buying back and rolling.. and this is where I am.
I agree with you, that we must have a plan before entering a trade… they were mismanaged, because I relied on the coaches and did what they advised to do. So I decided to take control and started learning, researching… and came across you.
Now I am in a desperate search for better strategies to help me get out of positions which seems rather impossible at this stage.
I am aware it won’t be easy and takes time. I am prepared to keep them for years, but there must be something I can do.
So I would like to ask please, if there is a way to save those terrible stocks that have gone down too much.
Do you think I can write a call OTM 8 to 10 % from the current price without conditional..(even though buying back would be expensive) and collect premium?
I tried to average down on X last year too, but not enough…
I can only think of those two strategies.
I would really appreciate your professional opinion.
Apologies for my long email, and thank you for your time to read it.
I never comment on other colleagues or methodologies but I’m happy to make these comments that should offer positive guidance.
Every covered call writer, including me, has made mistakes that cost us money, sometimes significant money. As painful as this is, it can turn out to be money well spent. If we learn a lesson as what not to do and apply those teachings to future trades, we benefit substantially over the years. We become better investors.
I congratulate you on your decision to take control of your financial future. That’s what the BCI community is all about… we learn from each other. The past has been a learning experience and that education should continue as it does for all of us. However, it will continue while beating the market on a consistent basis.
Regarding your unrealized losses: We shouldn’t care about the stocks but rather the cash allocated to those securities. Let’s say we started with $100,000.00 in stock that is now worth $20,00.00. Well, we have $20,000.00. We ask ourselves…where is that cash best placed?… in the same losing securities or with much better performers? Rhetorical question…
If we bought a car that continually breaks down and bleeding cash as we repair it in hopes that, one day, it will get us to our final destination, shouldn’t we sell it and buy a car that actually works? Another rhetorical question…
You made a decision to take control of your financial investments. Your future is bright. That will become more apparent as you master the 3-required skills (stock selection, option selection and position management).
Welcome to our BCI community.
Please keep in touch.
I’m on the same boat as NW. I’ve been pondering about selling the stocks and realizing the losses due to Covid, but I have the following reservations. Can you please help enlighten us, maybe there is a better way of looking at these:
1.) The stocks that went down also have the tendency to spike higher on news about reopening (i.e., retail stocks like RH, SNBR, LULU, etc.). Because of this, there is higher chance that even 8-10% OTM calls might get exercised below breakeven.
2.) If I sell OTM calls, and they become ITM (at a possible loss) near expiry, then I roll up for next month, there is risk that I might end up losing more money (due to higher call buyback price) when the stock drops back next month — like “hitting a double” in reverse. This has happened to MA, SOXX, NKE, etc, this month.
3.) Could the depressed prices be temporary? i.e., maybe they would bounce back to normal levels once the economy reopens? And these stocks that dropped fast also tend to rise faster when this happens, compared to covid performers like PYPL or MSFT.
4.) If I sell and move the cash to other stocks, there is no way to know for sure that the new stock would continue to outperform the stock I’m about to sell
Because of these, I’m unable to make a move on these stocks. What would you advise?
Thank you for everything that you do, Alan, I’ve learned a lot from you.
One of the most universal issues retail investors have is selling a stock at a loss. We must first identify what is most important to us and it’s the cash, not the stock. So, we ask ourselves where the cash we currently have invested in these securities best placed?
This is where a structured system makes life easy for us. Since we cannot accurately predict the future (no one can), especially during a market aberration like we are currently experiencing, we turn to our system criteria… fundamental, technical and common-sense principles. The cash in these current losing positions can grow in better-performers or in the current under-performers. Which should we opt for?
The concept that a trade isn’t a losing one until we sell a stock can hurt us. Even pillars of our economic society may not recover…Enron…Bear Stearns.
In my humble opinion, we will benefit over the long term if we:
1. Accept the fact that it is the cash and not the stock we should focus on.
2. Have a structured trading system based on non-emotional, sound fundamental, technical and common-sense requirements based on our trading style and personal risk-tolerance and then stick to it.
This market will eventually normalize and trading will become less challenging. Even in these strenuous times, by mastering the 3-required skills, we will continue to beat the market on a consistent basis.
When trading LEAPS what’s the preferred strike? In-the money, out of the money, or atm? Why?
Thanks for your assistance!
When using LEAPS as a stock surrogate for the Poor Man’s Covered Call (PMCC) strategy, BCI has the following guidelines:
1. Deltas of 0.75 or higher. These option prices will closely mirror the price movement of the underlying securities.
2. Deep in-the-money strikes will align with these Delta requirements.
3. “Ask” prices align with portfolio cash available.
4. The initial PMCC trade execution formula is adhered to.(see pages 117 – 133 in our book, “Covered Call Writing Alternative Strategies”).
As an example, I took a screenshot on the cboe.com website for Intel (INTC) which is currently trading at $58.30:
YELLOW: Deltas > 0.75
BROWN: Strikes with Deltas > 0.75
PURPLE: “ASK” prices of options that meet system criteria
CLICK ON IMAGE TO ENLARGE & USE THE BACK ARROW TO RETURN TO BLOG.
Good morning, Alan;
This was quite in the news yesterday; not sure if it would be a good option candidate. Thoughts?
Yesterday I finished my first month of trading options; I learned so much after reading your books and the first month of practice: bought 2 stocks (VIPS, JD) , sold covered calls; bought back the options , sold the stocks (lost a little) , then bought another stock (EBS), finished where I started.
I feel somehow more confident. I though also of swing trading.
NASDAQ:SRNESorrento Therapeutics Stock Price, Forecast & News
You’re off to a great start in a challenging market environment. For those staying in cash, paper-trading this market aberration is extremely useful.
SRNE is an appropriate covered call writing candidate for some but not for most. It has been news-driven as shown in Friday’s trading where there was a report of a favorable COVID-19 antibody experiment causing share price to skyrocket. The next report may not be as positive and then look-out-below!
Fundamentals and revenue growth are not especially impressive. Bottom line: This is a highly volatile security which returns huge option premiums but comes with just-as-huge downside risk. Be careful with this one.
Keep up the good work.
Thanks for all your valuable information and insight.
I trade C/Cs in both my IRA and Taxable Account. With respect to decisions in the taxable account I am on pretty sound footing using basis of lots purchased, assigning lots to exercised C/Cs etc. Because the situation is so different for an IRA with respect to tax and gains, etc. I am confused on what parameters to use for decision making re. strike price, etc. with respect to the IRA C/Cs.
Any summary response and guidance on where to find discussion of this topic would be appreciated.
Strike price selection whether in a sheltered or non-sheltered account is the same with one exception. Here are the BCI guidelines:
First, determine the “moneyness” of your options, ranging from all in-the-money (bearish) to all out-of-the-money (bullish). We can have a mix of ITM and OTM depending on the degree of bullishness/bearishness.
Once that is defined, we move to our pre-determined initial time return goal range (say 2% – 4% per month as an example). We then turn to an option-chain and look for strikes that meet both criteria. The “multiple tab” of the Ellman calculator will be quite useful in strike selection.
The one exception is when we trade in a non-sheltered account that consists of securities at a much lower-than-current cost-basis and we want to avoid substantial capital gains tax. In this case, we write only OTM calls with much lower initial time-value returns, perhaps 1/2% per month, as one example. This is “portfolio overwriting” and we have a book and calculator for this strategy:
This week’s Weekly Stock Screen And Watch List has been uploaded to The Blue Collar Investor Premium Member site and is available for download in the “Reports” section. Look for the report dated 05/15/20.
Also, be sure to check out the latest BCI Training Videos and “Ask Alan” segments. You can view them at The Blue Collar YouTube Channel. For your convenience, the link to the BCI YouTube Channel is:
Since we are in Earnings Season, be sure to read Alan’s article, “Constructing Your Covered Call Portfolio During Earnings Season”. You can access it at:
Barry and The Blue Collar Investor Team
I had done 5 covered calls and 3 put options expiring 5/15.
I invested about $50k and generated a premium of $2075 on these options for 40 days.
Two of my covered call options got called out generating an additional income of $1700.
My total income was $3775 for 40 days option trading.
How would you measure the ROI in this case?
Your 40-day return on premium + realized share gain is 7.55% which annualized to 68.9%.
This does not factor in the current price of the shares that were not sold which may result in higher or lower unrealized returns.
You’re off to an excellent start.
I saw yesterday that JCP is going into bankruptcy and it seams that the stock price will stay down for long because of the fundamental economic issues that the company is facing at the moment. Since the shares are super cheap I thought is a good idea to write a cc on the stock not because I’m interested in holding JC penny for the long term but to obtain income. I did an analysis on TOS platform and by buying 100 shares for around 150$ and selecting a strike of 0.5 I can I can double my investment if the price doesn’t reach the strike. What are your thoughts on this idea?
My preference is only use stocks with strong fundamentals
and technicals. JCP does not fit this mold. Covered call writing is a conservative strategy and by incorporating companies that have declared bankruptcy adds a risk element. Okay for some but not for most.
Even if the option returns look impressive, we must remember that option premium is related to implied volatility. The higher the implied volatility, the greater our risk.
Here is a link to an article I previously published on this topic
Hey Alan and Friends,
Alan’s recent use of cash positions, inverse ETF’s and high performing stocks in concert encouraged me to think differently. I decided to use a combination of the basic tools we are all familiar with for a trial trade for June starting this week on a core holding of mine QQQ.
I call it “The Sandwich Trade” but don’t try looking it up because I just made that up :)! It’s not that creative: it’s just a long put spread combined with a covered call. Like the minimum a stool needs to stand on it has three legs. So let me please explain it:
First the context. QQQ is a long term holding I can’t imagine ever not having in my IRA portfolio where I do all my options. I am ambivalent on it for June. If it goes up I would like some premium but keep some shares running unbothered. I am not “Sandwiching” all my shares. If it goes down I would love to add more. But if it really tanks I want some protection on the shares I put in play..
If you feel that way about one of your core IRA holdings please read on, if not, this idea is not for you. Using our BCI tools is what I will do.
1. If QQQ is up tomorrow I will sell a June covered call about 1% OTM above it to scratch the first itch of covering it on an up day
2. If QQQ sells off tomorrow I will sell an OTM CSP to scratch the second itch of maybe getting more cheaper?
3. I will give QQQ a couple more days
4. This is a Yo-Yo market. I will wait for QQQ to bounce back than I will buy a put underneath my CSP to protect it’s fall
5. When the trade is complete I will have accomplished three things we all know how to do: I will have sold a cc on an up day. I will have sold a csp on a down day and I will have bought a protective put on an up day beneath all of it
In my opinion since commissions went away and the market is a slinky going up and down stairs every day you have to leg in on trades like this to get best entry. Cost is per contract now, not per trade.
With two sold legs near the market and one under it this trade will be a net credit. So what’s the worst that can happen? Please ask that before you make any trade!
1. QQQ goes up big: I lose the shares I used in the trade, keep the appreciation and premium and the rest of holdings. A winner
2. QQQ goes nowhere: I keep the shares and the premiums. Another winner
3 QQQ goes below my sold strike: I add more at a price I agreed to discounted by the premium I took in adding to my net position as desired. Loser on paper for now but I like it longer term. Start new premiums for July
4. QQQ tanks. I add the shares at the price I agreed to and my loss on those is protected by the put I bought. The shares I left standing outside this trade are down depending on their original cost basis. So another paper loser I was prepared for. Sell something for July based on my assessment then.
So if you feel the same way I do for June expiry on something in your portfolio please have a “Sandwich” on me :)!. If not just follow your nose and look for other ways to apply our basic tools in different combinations!
All the best, – Jay
Good luck on your trade.
Your “Sandwich” is actually a covered combo and adding a protective put.
Please let us know how it turns out.
Funny how quickly things can change. With today’s vaccine news driving the market higher and was what a lot of sideline players may have been waiting for I am not as ambivalent on QQQ as I was. So I will hold the covered combo with put experiment for another time! – Jay
I am applying the BCI criteria for the first time on the Select Spider’s for June 19 (witching Friday) expiry.
1)Why was the XLP with a -1.16% 1 month and a -11.25% 3 month return selected rather than the XLY with a 5.46% 1 month and a – 14.31% 3 month return?
2) In this market re Spiders would you favour 5% OTM strikes if they generate at least 1% premium or do a combo of ITM and OTM strikes that generate between 1-2%? I am worried that if they go up too high I will not have enough capital to buy them back.
3)What is the advantage of selling covered calls against the best 3 Select Spiders versus the general SPY? I have read the complete BCI Encyclopedia for Covered call Writing and doing the Workbook but I am not sure what the advantages vs. cons are.
Is there another BCI tool available?
Donna, Premium member
1. XLV and XLK have been the strongest Selectsector SPDRs recently with several vying for that #3 slot. XLY did “overtake” XLP recently and most recently XLC has overtaken XLY. Today, I would rank them XLV, XLK and XLC on a 3-month basis. Several are close to the #3 slot. A new ETF Report will be posted on the member site tonight.
2. Currently I am using a mix of ITM and OTM strikes. It is our overall market assessment that dictates our strike “moneyness” mix. I am still cautious. With ETFs, my initial time-value return goal range is 1% – 2%. If a strike moves deep ITM, we may choose to allow assignment if the cost-to-close is too high or use the mid-contract unwind exit strategy to benefit from another new position if adequate cash is available.. If we allow assignment, we have maximized our trade… not so bad.
3. The advantage of using the top-3 SelectSector SPDRs is that we are using the top 27% of the S&P 500 on a performance basis rather than the entire index, increasing our opportunities for successful trades.
4. We have dozens of BCI products developed over the years. If you send me a direct email letting me know your strategy preference, the tools (books, DVDs, calculators etc.) that you already have, I’ll be happy to offer guidance.
I have a technical question hopefully someone more experienced can answer. With current market conditions I’ve been doing my homework on the collar strategy. In my paper trading, when stock price is below the put strike at the end of the contract period, I have to manually buy back the call then exercise the put. Is this normally how it’s done? I assumed that the call would expire worthless and my broker would automatically exercise my put, was I wrong about that? Thanks so much.
Hi Other Steve;
You assume correctly, the call would expire worthless and the put would be automatically exercised.
I am a Premium Member and am learning much and benefiting greatly from my membership.
I wonder what your thoughts are about weekly options vs the monthly time frame in this volatile market. For Boeing, the weekly % seems about the same with less possibility of missing a huge upswing…
My personal preference is to use Monthlys. That’s where I’ve had my greatest success. We can also achieve impressive results with Weeklys. There are pros and cons to Weeklys (as well as Monthlys). For example, Weeklys are terrific for circumnavigating around ex-dividend and earnings report dates but offer a much reduced pool of stocks (compared to Monthlys) that have these options associated with them.
For a detailed discussion of the pros and cons of Weeklys, see pages 30-35 in “The Complete Encyclopedia for Covered Call Writing- Volume II”
This week’s 8-page report of top-performing ETFs and analysis of ALL Select Sector Components has been uploaded to your premium site. The report also lists Top-performing ETFs with Weekly options as well as the implied volatility of all eligible candidates.
Also included is the mid-week market tone at the end of the report.
For your convenience, here is the link to login to the premium site:
NOT A PREMIUM MEMBER? Check out this link:
Alan and the BCI team
Thank you for your guidance and instruction.
I understand that you are using the 20% / 10% BTC on the option as our decision point for how to proceed with the underlying. I believe this will work only with correct strike selection. Therefore, do I use ROO of no less than 2% as a guide? I have heard you say many times “a return of 2-5%.” 2-5% on the entire trade or just ROO. The stock price would have to go down for the option to drop in price by 80% in the first week, 90% in the following weeks (for long calls) more than IV goes up.
All of the examples I can find that you provide shows a significant drop in the option price providing a chance for a double resulting in profit at the end of the trade. The only way I can see this happening is having a higher ROO (richer premiums).
I like being able to use the 20% / 10% rule as a line in the sand in place of a strict 8% decline in stock price. The option market makers price in more than just price action. That is the genius I see in this method.
Since we are experiencing more volatile markets with strong down moves, the 20% 10% rule is being triggered more often. So, to get a better handle on the method you teach, I want to be sure that I am selecting the correct strike to optimize the 20% 10% rule.
The 20%/10% guidelines are based on the time-value erosion (Theta) of our near-the-money option premiums (see the chart below).
This is one of the most useful management tools in our BCI methodology. These percentages apply to all strikes so we do not base our strike selection on the 20%/10% guidelines but rather on our strategy goals.
For strike selection, we first determine the “moneyness” selection of our strikes (OTM for bullish sentiment; ITM for defensive postures). I am currently favoring ITM 2-to-1 over OTM strikes.
From there, we turn to our pre-determined initial time-value return goal range (for me, it’s 2% – 4% for a monthly contract).
That’s it…we now view an option-chain that meets these parameters and the strike selection will be crystal clear.
Once we enter our covered call trade, we immediately enter a BTC limit order at 20% and change to 10% mid-contract. This way, we don’t have to be in front of our computer to take advantage of these exit strategy opportunities. This all becomes second nature after a while.
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I wish to add an observation to your question:
The 20/10 guideline is indicated for the stocks that have gone against our expectations.
We expect most of our trades to go up, but hopefully only a small part will normally go aginst our hopes.
When this happens in the first half of our one month option cycle, it is not good news, because the underlying stock has probably dropped more than 8%, and we are looking at a significant paper loss.
If we buy back the options at an 80% discount, we reduce this loss a little, and if we keep the stock and wait for a rebound, we may hit a double, and we risk the possibility of losing more.
Therefore we must be very careful, and evaluate the reason for the drop in that specific stock, or the whole market, before we decide to hold on to it.
I am glad to see your post.
We are hearing terrible news out of Brasil, especially São Paulo. Gee I hope all is well with you and your wife. I think of you and her almost daily. Seeing your post tells me you are still ok for now.
Take care old friend,