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Covered Call Options

Now, on this page I want to walk you throughoptions covered call writing Anna the mechanics of covered call options writing, and the things you need to be aware of as the trade unfolds, along with any decisions you may need to make whilst positions are open.

Covered Call Trading

OK, so we have opened our covered call options trade, either as a buy write or as an over write. What happens next and are there any decisions we need to make between now and expiry, and indeed what happens at the expiry date?

The short answer to the question is no, there are very few things you need to actually do, which makes it a nice strategy as you do not have to be in front of the screen all day. With your stop in place you have downside protection in case there are significant falls in the market so you are protected. The covered call option you have written is being traded in the market and may have been bought and sold many times over - you have no idea who holds the contract. The only thing you need to watch is if your stop loss is triggered, in which case you will need to close out your call option, otherwise you are trading naked and un-covered. How do you do this - you simply go into the options market and buy the call back, but make sure you buy the identical contract with the same strike price and expiry. This will then close out this trade.

Now, what actually happens at expiry, and do you need to do anything. Again the answer is no, it will all happen electronically and be executed by your broker. There are only two things that can happen: either you will be exercised or you will not!

Covered Call Example

It is the last day of trading for the options series and you are watching your screen to see what happens. Let's take the MCD example again, and suppose that the stock has risen in the last 2 weeks and is now trading at $55.60.  On expiry your call will be ITM by 60 cents ( time value zero). Your strike price on the call was $55. So on the Friday night, or possibly the Saturday morning, your broker will reconcile all the positions, and your 100 MCD stocks will be called away from your account and you will be credited with $5500, and the position closed as the option has now been exercised by the holder, who in return for paying you a premium of $95 has made a profit of $600 - 95, $510 dollars. Equity option contracts are called physical delivery as an actual delivery of stock takes place. Whether the holder actually takes delivery of the stock, or simply pockets the $60 premium on the option is between the holder and the broker. You have a profit on the trade of $95 plus $44 a total of $139 dollars.

Please remember to remove/cancel your stop loss from the account, otherwise it will remain a live order on your trading system!!!!

Covered Call Options

As before it is the last day of trading, and MCD stocks have drifted in price over the last two weeks and are now trading at $54.80. The call option has expired worthless as it it now OTM and the time value is zero. Your 100 MCD stocks remain in your account. You are now ready to start again on Monday, and write another call on the stock, probably again at $55 for November, or even a $57 November call, if the premium looks acceptable, and you never know, there may even be a dividend payable in November!

One last point on expiry - what happens if the strike price and the market price are identical or very close? The holder may or may not decide to exercise. With all the transaction costs it is unlikely, although you can never be sure. I have kept stock where the price has been a few cents above the strike, and been exercised where the strike and market price were identical - so you can never be sure. In some cases your broker will decide as options are often reconciled on a rota basis based on the date. If all the contracts are fulfilled and yours is left - so be it.

Covered Call Income

Now, in order for the call writing strategy to be as profitable as possible, you need to keep the trading costs to a minimum. Naturally you have two sets of costs - firstly the stock/share transaction and secondly the option. Options brokers tend to be expensive as it is a specialist trading technique, and when you are selling one contract at a time it is even more important that you have a low cost broker. In my experience, there is only one broker that I would ever use or recommend - they are a fantastic company that I have used myself. Their execution and costs are second to none, and they have both UK and US operations so you can trade all the relevant markets. The company is Interactive Brokers and if you would like any contact details please just let me know - you will not find a better company or cheaper stock/options executions anywhere else - trust me I should know. Below is the investor section from the front page of the site which I hope gives you a flavour.

Welcome to the Interactive Brokers Group, Inc. ("IBG") Investor Relations site. The company, through its subsidiaries, operates as an automated global electronic market maker and broker specializing in routing orders and executing and processing trades in securities, futures and foreign exchange instruments across over 70 electronic exchanges and trading venues worldwide. Our shares are listed on the NASDAQ Global Select Market under the stock ticker "IBKR".

OK, lastly let's look at possible returns using the covered calls writing approach and option writing.

 

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