Covered Call Writing

Hi, and a very warm welcome to my site which I hope will teach you everything you need to know about how to start covered call writing, so that by the end you will know how to write covered calls. As you may know I am a full time trader myself, and I know from personal experience how difficult it can be, to find informative and helpful sites online when you are starting out - hopefully this one will help! I do have several others on various aspects of trading, all free, so if you would like to have a look at these please click on the Making Bread Home Page above ( or here ), and it will take you there. Again all the information and advice is provided free.

For those of you who have never used covered call writing as part of your trading strategy, I hope this site will give you the confidence to include them in the future. I have recently published a new site all about online option trading so if you are new to options, please take a look as it covers all the basics and some of the other popular options trading strategies. As always on my sites, I have tried to explain everything clearly and simply, but if you do have any questions on call writing, then please just click the button above and ask me your question. There is no charge and everything on the site if provided free of charge, as with all my sites as I feel there are enough people out there trying to make money from novice traders.

If you would like to follow some of my trades, I do post regularly on Twitter which is often called a "micro blogging" service. For those of you who are not familiar with it, it is simply a quick way to stay in touch with friends, family and news. You only link to people who are of interest to you, and the longest message is limited to 140 characters, so messages are short and sweet! It is ideal for me as I can update very quickly from my screen with details of possible trades, opportunities, news and also details of when my other sites have had new posts added, so you are always in touch. If you would like to follow me, and you already have a Twitter account, please just click on the "follow me on twitter" link above, or alternatively open an account with Twitter and then follow me. In addition I am also on Facebook, and MySpace, and would be delighted to hear from you there. I will shortly be opening a trading room on FriendFeed which will be available for you to meet other traders and investors and to discuss trading ideas, problems and strategies, along with access to my own trading suggestions. So there is a great deal going on at the moment, and please don't forget, you can always ask me a question at the new 'Ask Anna' site, or simply review trading questions asked by others so I hope you enjoy this new site.

I am in the process of updating all my sites which will include daily posts and videos by me, about future market directions, suggested trades, and opportunities for future trades. In addition when a site has been updated with a new post or video then these details will also appear immediately, which I hope you will find useful, and I look forward to welcoming you via one of the above.

Covered Call Option Writing

Of all the options strategies, covered call option writing is perhaps one of the most widely accessible since it represents a relatively low risk approach to options trading, and yet it is often only used by small numbers of traders and investors, who have taken the time to fully understand the opportunities this strategy offers. I firmly believe that it provides an excellent stepping stone between the world of traditional cash markets such as stocks and shares, that we all know and understand, to the slightly more complex world of derivatives and options. The two elements come together using equity options and provide unique opportunities for both trader and investor alike. For the investor there is the opportunity to derive additional income from an existing portfolio, and for a trader a strategy to produce income from holding shares and stocks for relatively short periods. Herein lies one of the issues that must be addressed immediately. If you are someone who falls in love with their stocks then this strategy is probably not for you I'm afraid. It is more suited to the speculator or to an investor who is more interested in making money, rather than holding beloved shares year after year and never considering the prospect that there may be better returns available by letting some of the 'children' leave home!

This is often the difference between an investor and a speculator. It is a little bit like a house builder. If you have bought your plot of land and built your house, you are probably very loathe to sell it knowing all the love and hard work that has gone into it. A property speculator on the other hand would have no problem selling and moving on to the next project - they are in the business to make money - short and simple, and do not 'fall in love' with their properties. So, as I say, if you love your shares or stocks and feel unable to part with them ( a decision which will be made by someone else and in their timescale) then this is probably not for you. Now, let's look at the two elements which go to make up a covered call, namely stocks and equity options, and then start to look at the various covered call strategies.

Covered Calls Writing

The first element of a 'covered' call is the easy part, which is the stock or share itself. In the UK they tend to be called shares, and in the US stocks. There is a difference, but for most purposes the terms are interchangeable. Now, the 'covered' aspect of the strategy refers to the fact that the equity option is covered by your holding of the stocks or shares. You are covering the risk in selling the option by holding the underlying stock as security. So that in the event that you have to deliver on the option contract ( for an option is a contract as you will see shortly), then you have the stock to do it, in other words the risk is covered. This is why covered call writing is a low risk strategy, because even if market prices soar, you have already purchased your stock and can 'cover' or deliver on the contract at the required time. Let's take a simple example which I hope will illustrate the point.

Assume you live in one of twenty newly built houses. Most are still unsold by the developer. You meet a friend one evening and he says he would like to live in the same street as you, and you offer your house, as you are keen to move anyway. You agree a price and shake hands on the deal, and you ask your friend for a non refundable premium in order to hold the property for him. He agrees and pays you your premium. Over the next 4 weeks house prices rise dramatically, but you have agreed a price with your friend in return for the premium he paid you,  and so at the end of the month you give you friend the keys to your house and he pays you the agreed price. You also keep the premium that he paid. All you have 'lost' is the increase in the price of your property over the last four weeks, but you have delivered the underlying asset, the house, and kept the premium.

Now let's take the same scenario, but in this case you do not own a house in the street. You meet your friend who assumes that you do, and as before you agree a price to sell him something that you now do not own, and you take the premium from him as before. You do not tell your friend the truth as you think prices are going to fall in the next few weeks. Believing prices will decline, you gamble on making a quick profit by buying one of the empty properties at a lower price,  in order to sell to your friend in four weeks time at the agreed price. Unfortunately prices rise substantially, and you therefore have to buy on the open market at a much higher price, and sell to him at the agreed 'now lower' price, thus causing you to lose money. You still keep your premium. This in essence is the difference between covered calls, where you already own the underlying asset, and 'naked' where you do not!

You will hear the term ' naked call writing or naked calls - this is where the option seller has sold the equity option but does not own the underlying stock in case he or she is required to deliver on the contract. This is a very high risk strategy which I do not recommend. Your risk is unlimited. It is unlikely your broker will allow you do to anyway as you will be required to provide years of evidence of options trading. All I will say is don't even think of trading this way - enough said!

Writing Covered Call Options

Now, the second element is the option, or as it is called the equity option. OK, let's start with the basics - why do we have this odd term ' writing' - does it mean we actually write anything? The answer is no. Options first appeared in the early 19th Century in America, and were know then as privileges. These privileges or contracts were actually written by hand, a term which has applied ever since. The hand written contract was then sold by the writer to the buyer. So for 'writing' read 'seller'. In today's world of online trading the term still applies but only for historic reasons.

So what is an option? - in simple terms it is a contract to buy or sell a specific financial product, which is known as the options underlying instrument or underlying interest. In this case, the underlying instrument for an equity option is of course the equity ( share or stock ), hence the reason it is called an equity option. For a more detailed description have a look at the online option trading site.

In summary, just to recap, in order to write a covered call, we need to have two elements to the trade. Firstly we need to own the underlying instrument, the shares/stocks, and secondly we need to sell the equity option associated to these shares/stocks. Simple? well it is really, but there is a great deal more to learn about how to analyse the trading and investing opportunities this low risk strategy offers. Let's look at the risk profile of a covered call.

Covered Call Writing - Next Page