Have you ever thought about how to trade options? Consider exploring a covered call options trade. In this article, you'll how to make your first options trade.
Selling covered calls could help generate income from stocks you already own
So you own a bunch of stocks in your portfolio. Some have made a decent profit. You’ve heard you could potentially generate income from stocks you own by trading options. It sounds like a great idea, but options have their own risks, and knowing the stock world does not prepare you for those risks. Also, options trading seems complex, mysterious, and maybe even a tad bit intimidating. What’s the best way to start learning how to trade options?
First off, it’s best to understand what options really are. Options were designed to transfer risk from one trader to another. There are basically three reasons to trade options: as a speculative tool, as a hedge, and to generate income.
When trading options, one thing you’ll learn quickly is that options are not for everyone. There are many choices and strategies. There’s no one right way to trade options. It’s really about your objectives and risk tolerance.
Your options education starts with learning the difference between call and put options. A necessary starting point is to understand what calls and puts are.
A call option is a contract that gives the owner the right to buy (typically) 100 shares of the underlying security at a specific price (the “strike” price), any time before the expiration date of the option. The option seller has the obligation to sell the shares if the owner “exercises” their right to buy.
A put option is a contract that gives the owner the right to sell (typically) 100 shares of the underlying security at the strike price, any time before the expiration date of the option. The option seller has the obligation to buy the shares if the owner “exercises” their right to sell.
Don’t worry if words like assigned, exercised, obligation, and so on seem confusing. They’ll start to make more sense as you gain experience and become more educated about options trading.
If your objective is to earn some income on your stock positions, you could consider selling or “writing” a covered call.
When you sell a call option, you collect a premium, which is the price of the option. That premium, minus transaction costs, is the cash you receive in exchange for taking on the obligation to sell your stock shares at the strike price. But that doesn’t mean you should always go after the options with the highest premiums. It’s best to understand the risk/reward trade-offs by looking at how much you’d be risking versus how much you’re likely to gain. For example, the risk profile of a covered call in figure 1 shows that the profit is limited and the risk is almost unlimited.
FIGURE 1: RISK PROFILE OF COVERED CALL. Note that the upside potential is limited and the downside risk is essentially unlimited—at least, if the stock price were to fall to zero. For illustrative purposes only.
Also, remember that each options contract has an expiration date. That means you can’t sit on an option indefinitely just waiting for the price to reach your desired level.
OK, let’s get started with an example of a covered call trade. One standard options contract represents 100 shares, so choose a stock from your paperMoney® portfolio that:
Step 1. Analyze the options.
Open up your paperMoney account on the thinkorswim® platform (see figure 2).
Select the Trade tab, and enter the symbol of the stock you selected. You’ll see the usual details of the underlying stock at the top of the page. Below that (if the underlying asset is optionable), is the Option Chain, which lists all the expiration dates. Each date has several strike prices, which you can see when you select the down arrow to the left of the date. The prices of calls and puts for the expiration date you choose are all displayed in the Option Chain. Calls are displayed on the left side and puts on the right side. All the data you see is organized by strike price. Note that you can change the layout to display the variables you want to see (but customizing your layout is something you’ll do as your skill level advances).
Step 2. Choose the expiration date and strike.
When starting out, traders often consider choosing an expiration that is three weeks to two months away (the number of days to expiration is in parentheses next to the expiration date), although there are no hard-and-fast rules. The expiration you choose should give you a premium that’s worth the risk you’re taking. The strike you sell versus the underlying stock’s current price can make a big difference in the trade’s risk/reward profile.
That brings up another important decision. Do you sell a call with a strike price that’s the same as (or close to), higher than, or lower than the current stock price?
If you’re bullish on the stock, you may consider selling an OTM call. The premium will probably be lower than an ATM or ITM call, but if the stock price appreciates, you could make more profit. If your outlook is neutral, then you may want to write an ATM or ITM call. You may collect more premium than the OTM call, but with less upside profit potential for the stock and a higher probability of assignment.
Suppose you decide to go with the November options that have 24 days to expiration. The stock is trading at around $52, and you want a strike that’s slightly OTM. So you go with the November 53 strike call at $1.04. That means you collect $104 in premium, minus transaction costs. If you’re comfortable with the risk/reward trade-off—and if you’re not, there are plenty of other choices—you’re ready to place the trade.
For all of these examples, remember to multiply the options premium by 100, the multiplier for standard U.S. equity options contracts. So an options premium of $1 is really $100 per contract.
From the Trade tab (see figure 3):
Step 4: Send the order.
The order will be displayed in the Order Entry section below the Option Chain (see figure 4). Note that the price could change by the time you place the order.
When you select Confirm and Send, the dialog box will show you the break-even, max profit, max loss, and cost of the trade as if sold the call by itself. This is because in this example, we assumed we already owned the stock. However, if we were to buy the stock and sell the call at the same time, the dialog box would be different. If you like what you see, select the Send button, and the trade is on. When it’s filled, you’ve made your first options trade.
Even though you placed your options trade in a simulated account, don’t just forget about it. Take advantage of the opportunity to observe how the trade works out. There are three possible scenarios:
Note that it’s possible, even for a call that expired slightly out of the money, to be assigned, but notification won’t happen until the following Monday. So, be sure to confirm the status of the option after expiration before taking further steps involving that stock.
Remember, there’s a whole universe of choices and strategies when it comes to trading options, accompanied by a whole new world of risk, and not always just a “more” risk idea that is easy to grasp, but sometimes more complicated risk concepts. Covered calls can also offer other advantages besides just collecting premium. You’ve taken the first step by selling a covered call, but that may open up many more doors. With education, you’ll better understand how to manage risk, learn to modify strategies, get a better grasp of probability, and so on. So go on, explore your options.
After learning about options and deciding you want to trade them, you can apply for options trading approval by logging in to your account at tdameritrade.com. Under the Client Services tab, select My Profile. Under the General tab, you’ll see your approval status for options trading. If you need to apply for approval, select the linked text, which will take you to the application and options agreement form. Once you have your approval, you’re ready to begin trading options.
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Content intended for educational/informational purposes only. Not investment advice, or a recommendation of any security, strategy, or account type.
Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.
The covered call strategy can limit the upside potential of the underlying stock position, as the stock would likely be called away in the event of substantial stock price increase. Additionally, any downside protection provided to the related stock position is limited to the premium received. (Short options can be assigned at any time up to expiration regardless of the in-the-money amount.)
The paperMoney® trading application is for educational purposes only. Successful virtual trading during one time period does not guarantee successful investing of actual funds during a later time period as market conditions change continuously.
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Market volatility, volume, and system availability may delay account access and trade executions.
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