Understanding Options: Learning to Sell Time with Covered Calls
One of the simplest ways investors create income for themselves in the markets is learning to SELL TIME. Specifically, learning how to sell Option premium and collect income. In this article I will discuss how traders increase their ROI by using Options as a risk management tool to collect income.
Since options are instruments that are only good for a specified period of time, they are considered to be deteriorating assets. All things being equal, an Option will be worth less tomorrow than it is today, simply because it is closer to the expiration date.
A buyer of an Option has rights.
A seller (creator) of an Option has obligations.
This distinction is vital towards understanding how the Options universe operates.
A call Option is a contract that gives the buyer the legal right (but not the obligation) to buy 100 shares of the underlying stock at a pre-determined agreed upon price (strike price) any time on or before the expiration date of the contract, in exchange for the premium that they pay for that Option. The buyer of the Option enjoys limited risk and the most they can lose is the premium they paid for the option.
Let’s look at all of the components of an Options trade so that we familiarize ourselves with the language and mechanics of Options trading.
For this example, we will use a hypothetical stock called ABC Industries and assume it is trading at $100 a share.
ABC 100 June Call @ $5
ABC is the name of the stock symbol
$100 is the strike price or the agreed upon price that the stock will be purchased at between now and the expiration date.
June is the expiration date.
Call is the type of option. This gives the buyer the right but not the obligation to purchase ABC stock at $100 a share.
$5 is the premium that the buyer pays to the seller of the Option.
Let’s assume that there are only 10 trading sessions left till the Option’s expiration date.
Based upon these mechanics we can derive some very important trading information to decide whether we should buy, sell or stand aside on this Options trade.
Break Even price = Strike Price + Premium of the option.
If you wanted to buy this Option and planned to hold it till expiration your break even on the trade will always be the strike price ($100) plus the premium paid ($5).
In essence you are putting up $5.00 a share to have the right but not the obligation to own ABC at $105 between now and the expiration date.
Since there are 10 trading sessions left and the option will expire worthless at a price of $100 or below we can quickly surmise that “all things being equal” the option will deteriorate in value by .50 cents each day.
Option premium decay is what normally happens the closer that an options contract approaches expiration.
If ABC is trading above $105 at expiration you will make money as the options buyer. If it is trading below $105 you will lose money. The most amount you can lose is the premium which you paid. You will lose all of your premium payment at any price below $100 per share.
The easiest way to understand this is to simply determine what your ROI would be based upon the stock trading at a variety of different prices at expiration.
When I create a profit and loss graph of this scenario it looks like this for the options buyer.
What is attractive to the Options buyer is the fact that they have limited risk of $5 on this trade and theoretically unlimited profit potential. This occurs because the most they can lose is the Options premium, and since they have the right to purchase the stock at $105 at expiration they have theoretically unlimited profit potential.
Within this example though is an opportunity to understand RISK, REWARD and REALITY.
Instead of focusing on how much can I make, a good risk manager focuses on clearly defining risk and creating a strategy that can put the odds in their favor.
Here are some questions that a good trader will ask before entering into any trade:
Since the option only has ten days left to trade what are the chances that it will trade above the price of $105? In other words, how often has this stock rallied more than 5% in 10 trading sessions?
What has the trading range been for the last ten trading sessions assuming that the current trend continues into expiration?
What is the current trend on the stock?
Based upon these questions, a trader can devise a strategy that puts the odds more in their favor and manages their risk to a limited degree. The strategy that I am referring to is a Writing a Covered Call Option.
If the seller of the call Option also owns the underlying security, the Option is considered “covered” because he or she can deliver the underlying stock without having to purchase it on the open at possibly unfavorable pricing.
In this strategy you own the underlying stock at $100 a share. You also then agree to sell one June $100 call option at $5 per share. This obligates you to deliver your stock at $100 a share in exchange you received a $5 premium payment that goes into your account.
But more importantly this position offers tremendous flexibility. In the world of trading, power is defined as your ability to hold a position without being adversely affected. In this scenario, here are the dynamics of this unique strategy:
Break Even = Stock purchase Price – Premium Received
One of the best ways to understand Options is to ask yourself the question, what if I am right? And what if I am wrong?
The beauty of this strategy is that there are three outcomes and two of those outcomes are winners.
Scenario 1: The Stock Goes Down.
If the stock sells off to $95 at expiration, even though you own it at $100, you end up breaking even on the trade.
This occurs because you end up losing $5 on owning the stock at $100 per share but you simultaneously made $5 by selling the option and collecting $5.
At any price under $95 you end up losing on a direct 1 to 1 relationship as if you only owned the stock.
Scenario 2: The stock price stays relatively the same. Up a little, or down a little.
In this scenario, the Option premium which you collected either ends up expiring worthless, offsetting any negative price action in the stock. At any price $100 or above the stock gets called away from you and you keep all of the premium
Scenario 3: The Stock rises dramatically.
On the upside your maximum profit potential is $5 per share and this will occur at the price of $105 and above. This occurs because you would make money on your stock but you would lose money on the Option.
If the stock is above the $100 strike price at expiration, the call option will be assigned and you’ll have to sell 100 shares of the stock at a price of $100..
If the stock skyrockets, you might consider kicking yourself for missing out on any additional gains, but don’t. You made a conscious decision that you were willing to part with the stock at the strike price, and you achieved the maximum profit potential from the strategy.
Stated another way, this strategy will be profitable at any price above $95 and will generate the maximum profit potential at $105.
While the returns I have outlined in this example may sound small, you need to understand that this scenario will unfold over a period of ten trading sessions. The maximum gain is $5 or 5% but if you annualize that Return on Investment it is comparable to a several hundred percent return per year.
More importantly, and this is where understanding the risks and rewards of Options becomes super exciting, because what often happens in strategies like covered calls is that the market sells off but the contraction is less than the premium you collected. So you end up making money, even though the market worked against you. I am convinced that when you discover you can be wrong in your perspective of where the market is going and still make money, you will be hooked on Options trading forever.
This is what the profit and loss graph looks like on this covered call position.
Many investors use covered call writing as their entry into Options trading. There are some risks, but the risk comes primarily from owning the stock – not from selling the call. The sale of the Option only limits opportunity on the upside.
When running a covered call, you’re taking advantage of time decay on the Options you sold. Every day the stock doesn’t move, the call you sold will decline in value, which benefits you as the seller. Time decay is the most important concept to be aware of as traders because Options are deteriorating instruments. So as a beginner, it’s good for you to see it in action.
Since many stocks have Options which expire every week, understanding the mechanics of this strategy are vital towards creating tactics that continue to put the odds in your favor while simultaneously creating income in your portfolio.
But here is where things can get really exciting. Imagine using Artificial Intelligence to put the odds even further in your favor!
Vantagepoint forecasts trend direction up to 3 days in advance with up to 87.4% accuracy!
Great trading is never about how much you make when you are right. It is always about how little you lose when you are wrong. When you learn how to sell Options and collect premium against your existing stock positions you can actually be wrong and still make money. I just described this tactic in the example above.
Everybody has had horrible trades. The difference between the winners and losers in life is that the winners learned very powerful lessons from their losses.
What makes this possible is understanding the time decay of options premium as the Options contract approaches expiration.
Artificial intelligence is so powerful because it learns what doesn’t work, remembers it and then focuses on other paths to find a solution. This is the Feedback Loop that is responsible for building the fortunes of every successful trader I know.
Artificial Intelligence applies the mistake prevention as a continual process 24 hours a day, 365 days a year towards whatever problem it is looking to solve.
That should get you pretty excited because it is a game-changer.
This is the winning combination.
Find the trend.
Scrutinize the 1-3 day forecast.
Enter a Covered Call Options trade with minimal risk.
Be beautifully positioned before the herd even knows what happened.
Manage the RISK on the trade.
Lather. Rinse. Repeat.
The Answer AI offers may surprise you.
This is how small traders grow their accounts by taking small bites out of the market consistently.
Today Artificial Intelligence, Machine Learning and Neural Networks are an absolute necessity in protecting your portfolio.
I, like everybody else, have my opinions about what will happen next. But I never let my opinion get in the way of what the artificial intelligence is forecasting. Combining, ai with Covered Call Options writing is the “Cat’s Meow.”
While reporters, talking heads and analysts want to discuss esoteric economic ideas, my only loyalty as a trader is to the trend! This is how Vantagepoint artificial intelligence simplifies and empowers traders daily!
Intrigued? Visit with us and check out the a.i. at our Next Live Training.
Discover why artificial intelligence is the solution professional traders go-to for less risk, more rewards, and guaranteed peace of mind.
It’s not magic. It’s machine learning.
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