What are the characteristics of this option strategy?
Covered call positions pair 100 shares of an underlying asset (such as a stock) with one call option sold against those shares. This strategy is mostly used in the context of the stock market in order to add an income stream to a portfolio. The premium collected is the only cushion it provides. The shares underneath still carry their full downside, so a covered call reduces the cost basis rather than protecting the position.
Is this a bullish, bearish or neutral strategy?
The covered call option strategy can be used in any situation, whether bullish, bearish, or neutral. The strategy will generally work best in moderately bullish or neutral situations.
Is this a beginner or an advanced option strategy?
The covered call option strategy is a fairly straightforward strategy which can be suitable for beginners in option trading. However, the strategy can be implemented in a more advanced fashion with more complex options combinations.
In what situation will I use this strategy?
The covered call option strategy is typically used to generate an income stream from an existing or incoming long position in an underlying asset. It is sometimes described as a hedge, but the cushion it gives is only the premium received. A decline larger than that premium is a loss on the position.
Where does this strategy typically fall in the range of risk-reward and probability of profit?
The covered call option strategy has a capped reward and a large downside. The most the position can make is the call strike minus the share purchase price plus the premium collected. The most it can lose is the full purchase price of the shares minus the premium, which is only realized if the stock goes to zero. The probability of collecting the premium is typically quite high, but that high hit rate is paid for by the size of the loss on the rare large drop, so it is not a low risk position.
How is this strategy affected by the greeks?
The covered call option strategy is affected by the greeks, especially delta, gamma and theta. Delta is the rate of change of the option price with respect to the underlying asset price, gamma measures the rate of change of delta, and theta is the rate of change of the option price with respect to time.
In what volatility regime (i.e VIX level) would this strategy be optimal?
The covered call option strategy generally works best in calm to moderately volatile market environments, with the VIX level between 10-20. In these ranges, the option premiums are usually large enough to be worth collecting, while the underlying is less likely to make the kind of sharp drop that the premium cannot come close to offsetting. A low VIX does not reduce the risk in the share position itself, it only changes how much the short call pays for taking on the capped upside.
How do I adjust this strategy when the trade goes against me? And how easy or difficult is this strategy to adjust?
When the trade goes against the investor, they can adjust the strategy by rolling the short call out in time, and up in strike if the stock has run away from them, or by closing the option early and taking the loss. Rolling the call does nothing about a falling share price. Only selling the shares or buying a put addresses that. Adjusting the strategy is not too difficult, but it can require some understanding of the underlying asset and market conditions in order to make the best decisions.
Where does this strategy typically fall in the range of commission and fees?
Covered call option strategies typically fall in the middle of the range of commissions and fees associated with trading options. Commission rates are usually between $0.25 – $1.00 per contract, and there may be additional fees for margins or additional services such as data.
Is this a good option income strategy?
The covered call option strategy can be an effective way of generating income in fairly non-volatile markets, provided that it is used correctly. It is not suitable for all investors and market conditions. The income arrives in small, regular amounts while the loss, when it comes, arrives all at once through the shares, so the investor must be willing to own the stock through a drawdown.
How do I know when to exit this strategy?
The investor must be ready to exit the covered call option strategy if the underlying asset moves sharply against their position, or if the option premium drops significantly. Investors should also be aware of their overall portfolio positions, as a sharp movement in other positions may necessitate a change in strategy in order to offset the additional risk.
How will market makers respond to this trade being opened?
Market makers will typically respond to the opening of a covered call position by moving their bid and ask prices according to their market view, and the price of the underlying asset during that time. They will also adjust the option premiums to match their view of the market.
What is an example (with calculations) of this strategy?
To illustrate the covered call option strategy, let’s consider the example of buying 100 shares of Apple (AAPL) stock at $150 per share. At the same time, the investor also sells one call option with a strike price of $155, expiring in 3 months, for a premium of $7 per share. This would give the investor an immediate net credit of $700 (7 x 100), which is the premium collected.
If the stock trades above the strike price of $155 at expiration, the investor will be assigned on the option, as the option will be ‘in-the-money’. The investor will then be obligated to sell their 100 shares of AAPL at the strike price of $155, for a gross profit of $5 per share ($155 - $150), or $500 across the 100 shares. The net profit for the investor will be $1,200: the $500 gain on the shares plus the $700 premium collected, less commissions and any flat assignment fee the broker charges, which is typically under $20.
If the stock trades below the strike price at expiration, the investor keeps the $700 premium and the shares, but the shares are marked down too. The premium offsets only the first $7 per share of decline, so the whole position breaks even at $143 and loses money below that, with a worst case of $14,300 if AAPL went to zero.
How can MarketXLS help?
MarketXLS is a powerful platform for analyzing option strategies such as the covered call strategy. With MarketXLS, investors can quickly access live market data and options prices, create custom option spreadsheets, backtest strategies using historical data, and calculate the greeks for any options strategy. All of this can be done with the easy-to-use Excel interface, without having to learn any complex coding. MarketXLS is a great tool for traders of all kinds and can help take the guesswork out of option trading!
Here are some templates that you can use to create your own models
Covered Call Option Strategy
Collar Option Strategy
Covered Put
Covered Put
Search for all Templates here: https://marketxls.com/templates/
Relevant blogs that you can read to learn more about the topic
How to hedge a drop in S&P 500 Using MarketXLS
Options Investing: The Best Way to Profit from Volatility
Covered Calls – What They Are & How You Can Profit (With Marketxls Data)
Retirement Income Series: Find The Best Covered Call Option Using Marketxls
Collar Option Strategy – A Synopsis