Making Money with Covered Calls

With a covered call you lose less money if the stock price falls, and you can profit if it doesn’t move

• Moving to options from a portfolio that’s all stocks can certainly be can overwhelming experience.
• The covered call is a great strategy to use as a bridge from trading nothing but stocks to including some options.
• Not only does the covered call maintain a bullish bias like long stock, but it also increases your probability of profit to more than you would have with only stock.

Moving from an all-stock portfolio to a mix of stock and options can seem a daunting task. You need to familiarize yourself with a whole new language of options terminology. Plus, the risk-return profiles of options strategies are often far more complex than a simple long stock position. Not to mention that your directional bias in the market is very straightforward with long stock. If the stock rises in price, you make money. If the stock falls in price, you lose money. If the stock goes nowhere in price, you go nowhere with your position. With options, however, your directional bias on a given strategy can be far more dynamic than with just holding stock.

This is where the covered call can be a great bridge connecting stock to options. Not only do you maintain a bullish bias with a covered call as you have with long stock, but you’re also able to tap into the higher probabilities available with short options strategies.

Bullish bias

Arguably one of the biggest advantages of options is that you can easily customize whatever directional bias in the market you want. If you want to be bullish, you can be bullish. If you want to bearish, you can be bearish. If you want to be neutral, you can even be neutral. This flexibility, however, can be overwhelming for a new options trader who doesn’t feel equipped to make those directional decisions just yet.

A covered call, however, maintains the same bullish bias you had with long stock, just to a lesser degree. Long stock is a positive delta position (bullish) and a short call is a negative delta position (bearish), so when you combine long stock with a short call in a covered call, you introduce a bearish component to an otherwise bullish position. 

Specifically, if you have 100 shares of stock, then your delta on that position is +100. But if you add a short call with a -30 delta and create a covered call, then the net result is only +70 delta on the overall position. Therefore, you’re still bullish (something you’re comfortable with coming from an all-stock portfolio), but the degree to which you are bullish is only 70% of what it was with only stock.

Higher probability

Again, with stock, you make money if the stock rises, and you lose money if the stock falls—it’s pretty simple. But with a covered call, you still make money if the stock rises (because you’re still bullish), but you’ll also lose less if the stock falls and actually profit if the stock doesn’t move. 

While stock ownership is always a 50-50 proposition from day to day, by using a short call to create a covered call, you’re able to boost your probability of profit to well over 50% for two reasons. First, you have built in a buffer to the downside, so if the stock price does fall, the short call side of the strategy will benefit. This reduces the overall drawdown on the position’s profitability, and it makes jumping over the hurdle to positive profits much easier. Second, in the event the stock doesn’t move, the extrinsic value on that short call will be slowly decaying over time—turning what would otherwise be a nonevent for a long stock position into a profitable outcome for the Covered Call holder.

Jim Schultz, a quantitative expert and finance Ph.D., has been trading the markets for nearly two decades. He hosts From Theory to Practice, Monday-Friday on tastylive, where he explains theoretical trading concepts and provides a practical application of those concepts to a trading portfolio. @jschultzf3 

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