A covered call options trading position is generally used to generate additional income in a stock with a neutral to mildly bullish outlook. The stock can be either owned previously or be purchased at the same time the option position is established. The basic premise of a covered call is to buy or already be long stock and sell a call with a higher strike price than the current stock price. As long as the stock stays below the strike price you keep the premium. If the stock goes above your strike price at expiration the stock is called away from you and your profit is capped.
Let’s look at the current market and find a covered call play. For this example we will round prices, and use the basic 100 shares of the underlying/1 option contract. Check the options chains for the latest prices.
Hansen Natural Corporation (NASDAQ: HANS) – $72.50
HANS markets alternative beverages including the brands Monster Energy, Java Monster and Hansen’s Natural Sodas.
It has been slowly climbing upward since the beginning of the year. It has very good fundamentals and the stock has had a nice run since the beginning of May. The overall market could be poised for even more of a pullback and HANS has support in the $66 area. If HANS does decline some, it might be advantageous to generate some income and give the stock a chance to recover. If HANS never declines, profit is generated from the rise of the stock itself.
HANS Covered Call Options Trade:
Buy 100 shares HANS @ 72.50 and sell HANS July 75 Calls for 1.60.
Cost of the trade: 100 x 72.50 = $7,250 – $160 (1.60 x 100 premium received) = $7,090
Maximum profit: $410, if HANS finishes at or above $75 @ expiration. That’s $250 (the difference between the 75 and 72.50 strikes), plus the $160 premium received.
Breakeven: If HANS is at $70.90 (72.50-1.60) @ expiration
Maximum loss: $7,090 if HANS goes to $0
The optimum goal for a covered call is for the stock to finish right at the strike that was sold. The person A) keeps the stock, B) keeps the premium from the option expiring worthless and C) the stock is worth as much as possible without being called away.
And after expiration, the trader is free to do the same strategy with next month’s options—a technique called rolling.
Unfortunately, it doesn’t always workout so perfectly and managing a covered call can be a little more difficult than establishing the trade itself. The problem is there is little downside protection for the stock itself.
Find more option analysis and trading ideas at Options Trading Strategies.
Here are a couple of scenarios that may happen to HANS and a covered call strategy and what a trader may do regarding the trade:
Do nothing — If HANS goes up but stays under $75 at expiration you collect your option premium. The stock has also gained value for you and you can start the whole process over again by selling next month’s option. If the stock goes over $75 at expiration, the stock is called away from you but you have reached your maximum profit. If HANS goes down, money is made on the call option expiring worthless, though the stock drop may lead to overall losses.
Liquidate the whole position — If the HANS tanks and you lose as much money as you are willing to risk then simply sell the stock. You may want to also buy back the call option though the chances of it being exercised are probably slim. If you do choose to sell the stock and buy the option back you will be flat.
Roll out or down — imagine HANS dropped to the support level but the investor still thinks it will recover. In that case two things can be done. Buy back the call option at the reduced price and either sell another 75 call in a further out month or sell a lower strike call like the July 70. This is a repair strategy and if the stock breaks below support, you might look at liquidating the entire position based on what you were willing to risk on the trade.
Rolling up — HANS could rally past $75 at any time prior to expiration. That means the call you sold could be exercised and your stock taken away. If you want to hold on to HANS you can the buy back the July 75 Call and sell another at a higher strike. There may be a loss on the option but the gain in the value of the stock will more than negate it.
Dan Passarelli of MarketTaker.com writes the Market Taker Edge options newsletter. Dan has more than 17 years’ experience in the options industry as a market maker, Options Institute instructor and author of “Trading Option Greeks.”