Episode 08

The Covered Call Strategy with JJ Kinahan

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Listen to JJ Kinahan, Chief Market Strategist at TD Ameritrade, and guests talk about the covered call strategy and how it can be used to potentially generate additional income from stocks you own.

Audio Transcript


This is Understanding Options. I'm your host, JJ Kinahan.


JJ: Hello, everyone. I'm JJ Kinahan, Chief Market Strategist a TD Ameritrade, and welcome again to our podcast series Understanding Options. I am joined today by two of the smartest guys in the industry, TD Ameritrade Education Coaches, Ben Watson and Pat Mullaly. And today, we're going to discuss covered calls. Thanks for joining me today, guys.

Ben & Pat: Hey JJ. Good to be here.

JJ: Covered calls. I will call it the gateway, if you will, because I think that it's one of the first options strategies that most people use. It's the most commonly used option strategy used here at TD Ameritrade. So Pat, you know, any thoughts on how new traders think about it, et cetera, or why we do teach that so much to new traders?

Pat: Well, you know, I find it very interesting, I guess, maybe because after you've done it for a while, things-- you try and understand everything. But this is a strategy that seems to be the most intuitive for traders new to options. They understand stock, and they seem to understand about selling calls. They get putting those two things together, more quickly than they would a lot of other strategies that are out there.

Ben: All right, Pat, before we get to that, let's talk just briefly about the basics of call options.

Pat: OK.

Ben: We make sure that everybody has an understanding of that, right? So when we talk about a call option, the owner of a call option, the buyer of a call option has the right to buy an underlying stock at a strike price that's agreed upon. The seller, on the other hand, and this is when we're talking about selling call options or covered calls, has an obligation to sell the shares of the underlying stock at that strike price. So two sides of the coin here. We get the buyer, and we've got the seller.

And remember that one call typically equals 100 shares of the underlying stock. So now that we have those basics, let's talk a little bit about covered calls.

Pat: So I think the operative word you said there was obligation. And everybody needs to understand that, that when you're writing a call, it means you're selling that call to somebody, and that you have the obligation to turn your stock over to them if it gets called away.

The potential, now if you're just writing a call, what we might call naked, the potential for losses on that call, are theoretically unlimited, meaning in theory, a stock could continue to go up, up, and up. And that means that if you've sold that call to somebody at a certain strike price, they have the right to call you away at $50. Well, if that stock is trading at $300, and you do not own that stock, then you're on the hook to buy that stock at 300 and sell it to them for 50.

So with the covered call, though, however, you already own the stock. You're the buyer of the stock. You own that stock already. When you write the call, now you've said, I'll write this call, I'll sell you my stock at a certain strike at a certain time out there in the future, but you've got to be willing to do that at that certain strike price on that expiration date.

JJ: Yeah, you know you bring up a lot of things about placing this trade, and I think when you look at a covered call, and you look at selling a stock at a limit price, there are many similarities. There are a few differences we're going to talk about here in a moment. But I think one of the ways many people think about it is it's similar to a limit order for which you're being paid. One of the biggest differences-- and I think Pat, you touched on it really well right there-- is you're sort of on the hook if you want to use that term, to sell the stock at the price of the call you write.

So when you write that call, be comfortable that that's where you want to sell the stock in the time frame that you wrote the call for. And I always joke with people, everybody is-- if a stock's trading 45, everybody is comfortable with saying I'm going to be comfortable selling the stock at 50 in 60 days, except for on day 59, if it's trading up there, then like oh no, I don't want to do that. So again, you have to be disciplined, and you have to understand that you're going to be on the hook to sell there.

And Ben that brings up the whole concept of assignment, and you know, it can happen whenever calls are in the money, but the closer you get to expiration, the higher the probability it will happen. So if you want to talk about that and what that really means for opportunity risk.

Ben: Absolutely. JJ, I think you made a very good point in that any time you are short a call, or you've sold that call, whether you're in the money or out of the money, there is the potential that you could get a sign, and as you said, the closer you get to expiration, the more likely that scenario is to happen, and when you get assigned that call option or assigned to respond to the obligation that you created, those shares will be called away, and that creates that opportunity risk. The opportunity, the risk, is simply this: If you no longer own the shares of the underlying stock, you no longer have the opportunity to take advantage of that stock going higher and continuing to move up. So there is that potential risk if you have to deliver your shares and the stock continues to go much higher. You've lost out on that chance.

Pat: Yeah. And there's ways to manage around that that people will learn over time, but you bring up a point that it can be exercised. That person can exercise that if they want that stock, and there's other reasons to exercise that, not just because it's in the money or at the money. There's dividend risk. If we own a stock that pays a dividend, and somebody wants that dividend, and they own that call, they own that call option, and we've sold it to them, then we're obligated to sell them that stock if they want to buy that pre-dividend. Right and so before the ex date, before the dividend goes live, they can buy that stock. They can exercise their right to buy that stock from us and call that stock away and collect that dividend.

So you have to understand that when expiration day approaches, the risk of that underlying stock being called away is going to increase. And if that happens, your eligibility, my eligibility, whose ever of getting that dividend is going to be lost, right? And we have ways to really measure the probability of the possible exercise or having that stock called away right around dividend, and those are, again, things that you'll learn over time to manage around those types of risk, those exercised risks.

JJ: Well, and Pat, you bring up an important point, and that's why we like to start with out of the money options, rather than in the money, because most people will not exercise a call that's out of the money for a dividend, unless it's a really oversized dividend. So I think that's important to keep in mind. But why I really like this strategy is because it is the first one that many people use is it gets you in the habit of using risk-defined strategy. Know what you can make. Know what you can lose. Know what your frame is and know the probability of things happening. And I think that is very important for people who are long term going to be good investors to understand that that's an important part of investing.

And you know, you do get to earn some extra income, because of the premium, but you are giving up some upside, and I think that's really what the trade off is here and what are you willing to do on that trade off. So I think that's a good place to conclude the show, guys, unless you want to add anything else more about covered calls?

Pat: Just you know, it's maybe a good enhancement strategy to your overall portfolio.

JJ: I agree 100%. All right, and that does conclude today's show. So first of all, I want to thank my co-hosts for a fountain of knowledge as always, Ben and Pat, thank you guys very much. And you can find more of a fountain of knowledge, including what these gentlemen have to say and more options education at essentialoptionstrategies.com. As always, you can find me on Twitter at @TDAJJKinahan. Ben, where am I going to find you, buddy?

Ben: @BenWatson_TDA on Twitter.

JJ: And you are going to find Pat Mullaly every single day bringing you knowledge through TD Ameritrade Education. Does a great job, along with Ben. Thanks to you guys for joining us. Thanks to all of you for listening. We really do appreciate it. Please subscribe to the podcast. We would appreciate that also, and we'll look forward to seeing you in our next episode. And as always, good luck on your investing and good trading, everybody.

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