Introduction To Writing Out Of The Money Covered Calls
Writing out-of-the-money(OTM) covered calls is a strategy that involves selling out of the money call option contracts against the ownership of the underlying stock. The OTM( Out-Of-The-Money) covered call is a very popular strategy as it allows investors who go long on the underlying security to earn option premium periodically while having the potential to profit from upside moves of the underlying security as the price of the underlying security and strike price converges.
Margin requirement for covered call position
Margin is required by brokers to execute covered call positions. The amount of margin required is determined by the broker that the trader is using. Enquire with your selected broker regarding this matter.
Steps
Step 1 : Perform economic, fundamental and technical analysis
Step 2 : Assessment Of Outlook – Moderately Bullish
Step 3 : Study the option chain
Step 4 : Breakeven Analysis
Step 5: Understand Your Profit Zones
Step 6 : Potential for unlimited losses
Step 7 : Loss calculation
Step 8 : Limited profit potential
Step 9 : Calculation of profit
Step 10 : Calculate Risk & Reward Ratio
Step 11 : Set Up Trade – Executing an out of the money covered call
Step 12 : Exiting a covered call
Step 13 : Record Trade In Diary
Step 1 : Perform economic, fundamental and technical analysis
For OTM covered call to be executed successfully, the trader must start off with performing economic analysis. The economy should preferably be in expansion mode. After all, a growing economy will lift the securities in the market in a general sense. After which, the trader should perform fundamental analysis to ensure that there is a probability of the underlying security trading upwards. Last but not least, the trader would find to find the optimal entry and exit points to maximise profitability by performing technical analysis. Some chart patterns that the trader should look out for are:
Do note that these suggested chart patterns are not meant to be exhaustive. The whole idea is that there is some upward bias to be seen in these charts.
For more read : Basic economic analysis , Basic fundamental analysis , Introduction to technical analysis.
Step 2 : Assessment Of Outlook – Moderately Bullish
After performing economic, fundamental and technical analysis, the trader should be moderately bullish on the markets and the underlying security. A trader that uses an out of the money covered call is usually moderately bullish on the price of the underlying security. He gets to enjoy capital gains and profit from the price of the underlying security when the price of the underlying security rises. If a trader is extremely bullish on the underlying security, he should opt for a more aggressive strategy such as the long call strategy.
Read : Long Call : Profit From Rise In Price Of Underlying security
Step 3 :Study the option chain
Next, examine the options chain and select the call option to be used in the strategy. Do note that the call option has a strike price that is above the current trading price of the underlying security.
To know more about how to read an options chain , read : Learn to read and understand options chain
Step 4 : Breakeven Analysis
The trader should also be able to calculate the breakeven point of the strategy. The breakeven point can be calculated by the formula below:
Breakeven price point = Acquisition price of the underlying security – premiums received from writing call
The acquisition price is the purchase price of the underlying security.
Step 5: Understand Your Profit Zones
Calculating the breakeven point is important. Knowing where the breakeven point is, the trader should understand that for an OTM covered call strategy, the profit zone is to the right of the breakeven point.
Step 6 : Potential for unlimited losses
When an investor owns the underlying stock, the potential for losses is unlimited even with written call. The written call does not provide any protection to declines in the price of the underlying security. So when the price of the underlying security decreases, losses can mount. The writing of the OTM call option allows the investor to collect premium which acts to reduce the cost acquiring the underlying security.
For example, XYZ company trades at $43. An investor buys 100 shares of XYZ company for $4300 and sells a JULY 45 OTM(Out-of-the-money) call option and collects a premium of $200.
Effective acquisition price is :
$4300 – $200 = $4100
Thus the writing of the call reduces the average cost of acquisition of the underlying security from $4300 to $4100.
Step 7 : Loss calculation
A loss occurs on a OTM(out-of-the-money) covered call trade when the price of the underlying security is less than the effective acquisition price of the underlying security. In layman terms, a loss occurs when the price of the underlying security must be less than or equal to acquisition price of the underlying security less than premium collected from the written call.
Loss = Acquisition price of the underlying security – Price of the underlying security(this is lower than acquisition price) – premium received from writing OTM calls + brokerage commissions
Maximum possible loss
The maximum possible loss can be calculated as :
Stock purchase price – premiums received from the writing of OTM call options.
This occurs when the price of the underlying security goes all the way to zero.
Step 8 : Limited profit potential
The profit potential of a covered call is limited due to the obligation of the call option writer to sell shares when the price of the underlying security exceeds the exercise price and the call buyer decides to exercise the right to buy. Hence, profit will always be capped and limited with a covered call.
When the covered call is written, a premium is collected that acts the reduce the acquisition price of the underlying security.
Step 9 : Calculation of profit
The maximum profit occurs when the price of the underlying security is greater or equal to the price of the short call.
Maximum profit of an OTM covered call = Exercise(Strike) price of short call – acquisition price of the underlying security + Premium received from writing call – commissions paid to the broker
Step 10 : Calculate Risk & Reward Ratio
Where possible, the options trader should calculate the risk and reward ratio of the OTM covered call strategy based on possible exit points where stop losses are placed and the maximum possible profit. This allows the trader to determine the attractiveness of the trade relative to trades of a similar nature. A high reward to risk ratio is hence ideal for the trader. Also, do understand that the risk and reward ratio is constrained by the strategy used. Hence, it is imperative to compare the risk and reward ratio of one trade to a another of the same strategy.
Read : Understanding Risk/Reward Ratio For Option Traders
Step 11 : Set Up Trade – Executing an out of the money covered call
- Purchase 100 shares of underlying stock
- Sell 1 out of the money call options contract
Step 12 : Exiting a covered call
- If the price of the underlying security rises above the exercise price of the call option, the writer of the covered call can use the shares from the long stock position to sell it to the buyer of the call option, thereby satisfying the obligation to sell the shares. There is no need to purchase additional shares in the open market when assignment occurs..
- The price of the underlying security could fall below the exercise price of the call. When that happens, the written call will expire worthless and the option trader gets to keep the entire call premium. The trader can choose to write another call against the long stock position to offset the risk on the long stock position.
- If the price of the underlying security falls below the exercise price of the call and is also lower than the breakeven point, the trader can hold onto the stock and wait for an upswing in price and still exit at a significant profit.
Step 13 : Record Trade In Diary
After the trade has been exited, the trader should record the trade in a diary or a journal. He should reflect and review the trade. Where possible, the trader should make every attempt to improve on his personal trading algorithm.
Example Of Writing OTM Covered Calls
PQR company is trading at $40 currently. An investor decides to write 1 current month December 45(exercise price of $45) OTM(Out of the money) call option contract and buy 100 shares of PQR company. He pays $4000 for the 100 shares and collects a premium of $200 for the shorted call option. His effective purchase price is thus:
$4000 – $200 = $3800
As you can see, writing a call against ownership of shares acts to reduce the purchase price of the shares.
If PQR company trades at $46 on the expiration date of the option, the investor earns a maximum profit of $700 without taking into account commissions paid to a broker. (Commissions paid to a broker varies depending on the brokerage firm). How does one arrive at $700 of profit?
When the call option expires in the money because the underlying security price is above the exercise price of the shorted call, the call option buyer exercises the right to buy those 100 shares and the option writer has to sell those shares to the call buyer. When that happens, the call writer has to sell at the exercise price of 45, hence, collecting $4500 from the sale. Since his effective purchase price of the shares was $3800( after taking into account premiums collected), the investor’s profit is:
$4500 – $3800 = $700
You could look at it another way. The 100 shares are sold at $46 and the call option position is closed at $100(buy back the call option at $100).
The profit on the call option is : $200 – $100 = $100
The profit on the shares is : ($46 – $40) x 100 = $600
Total profit of the trade(without taking into account commissions) = $600 + $100 = $700
If the price of PQR trades at $35 instead, the investor makes a paper loss. Since his effective purchase price is $3800, the paper loss is calculated as :
$3800 – $3500 = $300
Paper loss can also be calculated as : $4000(Acquisition price of stock) – $3500(price of underlying security) + $200(collected premium from short call) = $300
In this case, if the investor is convinced of the long term prospects of the company, he could hold onto the shares for a profit in the long term and he could continuously write OTM calls against it, collecting premium as the stick gradually rises.
Comparable strategies
- uncovered written put
- Stock repair strategy
- In the money covered call
Read next: In the money covered call
You may also read : General Overview Of Covered Calls and