Covered Calls: Why Non-Option Traders Should Still Use Options to Hedge

The term sounds complicated… maybe even intimidating. But, it’s not. In fact, covered calls are in most regards less risky, and more predictable, than straightforward option trades. Investors that have traditionally steered clear of options should consider them for this one particular use.

But, first things first.

An option is just what it sounds like… an option to buy or sell shares of a particular stock at a pre-determined price within a finite timeframe. The buyer of a put owns the right to sell 100 shares of a particular stock, and the owner of a call option owns the right to buy 100 shares of a certain stock before that option expires. Owners of call and puts, however, are not required to buy or sell anything. They have the option to do so.

The right to buy or sell stocks at a pre-set price has a value, which changes as the value of the underlying stock changes.

There’s a counter-party to the purchase of a call option or put option though. That is, the seller ‘writes’ calls or puts, giving the option — or choice — to the buyer of those calls or puts. Why would a trader do that? Because buying options requires a payment. Selling an option collects a payment in exchange for the loss of control.

There are many cases where giving up that control of 100 shares of a particular stock is a perfectly palatable practice. Covered calls are one of those cases.

Writing covered calls simply means the writing, or selling, of calls are already ‘covered’ by shares owned by the party selling those calls. If the buyer of a call wanted to exercise the option to buy 100 shares of XYZ stock, doing so would force the seller of the call to buy those 100 shares of that stock in the open market, regardless of the price of the stock at the time. If the seller, or writer of the call already owns enough shares of the stock to simply deliver to the call’s owner upon exercise, those shares are simply transacted at the stock option’s strike price. The seller isn’t necessarily disadvantaged, and more important, won’t have to come up with the cash to pay any difference in the cost between buying and selling shares of that stock.

The usual follow-up question: Why would anybody ever give up such control of a stock they owned?

Answer: When they want to drive a little extra income from an existing stock position, and they wouldn’t mind exiting the position anyway.

As is always the case, an example will make much more sense of the matter.

Let’s create two hypothetical investors for the purpose of the illustration.

Sheila owns 700 shares of Netflix (NFLXWealth Strength IndexAAPL is Extremely Up and trending Up). She’s happy with the 275% gain she’s reaped over the past two and a half years, though she’s now concerned there may be no more upside left. She hasn’t sold the position yet, and isn’t entirely convinced she even wants to. But, she’s  concerned shares are overbought and ripe for a pullback. Sheila wouldn’t actually care if she made an exit from the trade now, even if it would create a taxable gain.

Sheila’s position is the perfect setup for a covered call trade, which might cause her to exit the trade, but would definitely put some extra money in her portfolio right now.

With NFLXWealth Strength IndexAAPL is Extremely Up and trending Up presently priced at $360.40, Sheila could sell, or write, seven March 22nd 370 calls to Larry. Currently priced at $7.65, or $765 per contract [one contract controls 100 shares of the underlying stock], selling those seven contracts would put $5355 in Sheila’s portfolio right now.

If Sheila does nothing else to unwind that trade, she’s guaranteed to keep that $5355 in her pocket. She might be forced by Larry to sell her 700 shares of Netflix to Larry for $370 apiece — the strike price of the calls that will expire on March 22nd — when they’re actually trading at a market price of more than that. But, she doesn’t really care. She’s still going to lock in a nice gain on Amazon, get them out of her portfolio to make room for something else, and still keep the $5355 in proceeds.

The only thing Sheila is giving up is control, which she doesn’t really need or want.

Larry’s situation is different. He distinctly thinks Netflix stock is going to move well above $370 before March 22nd, and he’s willing to pay $5355 to Sheila to make that bet using seven call option contracts.

If he’s wrong — if Netflix doesn’t move above $370 within the next few weeks — the calls we bought will expire worthless and he’ll lose the whole amount invested. If instead he buys those seven contracts from Sheila and NFLXWealth Strength IndexAAPL is Extremely Up and trending Up soars to $400 per share, he can force Sheila to sell her shares to him at a price of only $370 each. Larry will instantaneously be ‘up’ $21,000 (700 shares x the $30 difference in purchase price and market price), and even after subtracting the $5355 he had to spend to enter the trade, he’s still up $15,645.

Sheila doesn’t care. Sure, she would have rather ridden her Netflix shares up to $400, but she was ready to sell anyway, and still booked a big gain for herself.

Bottom Line on Covered Calls

As is the case with all trades, covered calls present a trade-off to their users. The trade off is a potential missed opportunity for upside, but cash-in-hand. Clever users of covered calls can often figure out just which strike price to use that always prevents the buyer of the calls from exercising his or her option, but still maximizes the small but steady stream of cash an existing stock position can provide.

Interested investors should, as always, ‘paper trade’ covered call trades to fully understand the nuances and mechanics. They may be relatively simple, but covered calls can actually be frustrating if trying to force such a trade where options are not ideally priced.