The 10 Best Options Trading Strategies — Part 1

COVERED CALL

Selecting and executing an options strategy, such as the covered call, is akin to navigating a vehicle. Despite the numerous components in play, once you grasp the intricacies, you can guide yourself toward your financial goals. However, before you initiate the process, it’s crucial to comprehend and feel at ease with the associated risks.

What attracts investors to the covered call options strategy? A covered call affords another party the privilege to buy stock shares you already own (hence the term “covered”) at a predetermined price (strike price) and at any point on or before a specified date (expiration date). This strategy has the potential to generate additional income from stocks already in your portfolio. Naturally, there are no risk-free gains; your stock might be called away at any time during the option’s lifespan. Nevertheless, the act of selling (or “writing”) covered calls presents various other potential benefits that some investors might not fully grasp.

So, let’s delve into the details and examine three aspects of this fundamental options strategy: selling stock, collecting dividends, and potentially reducing tax liabilities.

Exit a long position

The covered call stands out as an often overlooked method for selling stocks. If you have a predetermined target price for selling, it might be worthwhile to explore the option of generating additional income through this approach.

Here’s a breakdown of how it operates: Imagine XYZ stock is currently valued at $23 per share, and you intend to sell your 100 shares at $25 per share. While you could sell your XYZ shares immediately in your brokerage account for $23 per share, an alternative is to sell (write) a covered call with a strike price matching your target of $25 per share.

Refer to the risk profile chart for the covered call below.

When you sell the call, you receive cash (premium) deposited directly into your account, minus transaction costs. This cash remains yours, regardless of the subsequent fate of the underlying shares. If XYZ surpasses $25 at any point before the option expires, there’s a high likelihood that your short option will be assigned, leading to your XYZ shares being called away at the strike price. This outcome may align with your plan; you earned a premium for selling the call and gained an additional two points in stock value (from $23 to $25).

As intended, the stock is sold at your targeted price ($25) by being called away. If the stock exceeds $25, you achieve your desired outcome, but no additional profit is realized. This is because you committed to selling XYZ at $25. You pocketed the premium and earned an extra two points when your stock was sold, yet you won’t partake in any appreciation beyond the strike price. Additionally, bear in mind that transaction costs (commissions, contract fees, and options assignment fees) will diminish your overall gains.

Conversely: Despite your desire to sell XYZ at $25, there exists the possibility that the stock’s price could decline, dropping from $23 to $20 or even lower. In such a scenario, you retain the premium you initially received and still hold the stock when the expiration date arrives. However, instead of gaining the anticipated two points, you now face the potential for a loss, contingent upon the price at which you initially acquired XYZ. Essentially, this strategy offers some downside protection, but it is confined to the cash received when the option was sold.

Key point: Many option traders dedicate significant time to analyzing underlying stocks in an effort to preempt unforeseen setbacks. Their research aims to enhance the likelihood of selecting stocks that are less prone to significant, unexpected price declines. Nevertheless, it’s crucial to acknowledge that, regardless of the extent of research conducted, surprises are always a conceivable factor.

Another key point: Whenever your covered call option is at the money (ATM) or in the money (ITM), there’s a risk of your stock being called away. The deeper your option ventures into in-the-money territory throughout its duration, the greater the likelihood that your stock will be called away and sold at the strike price.

Remember: If your option is in the money by a mere penny at expiration, it is highly probable that your stock will be called away.

Sell covered calls for premium

Engaging in covered call sales can evoke a sensation akin to achieving a triple play. Upon selling a covered call on XYZ, you not only acquire the premium but also continue to receive dividends, if any, and retain potential capital gains on the underlying stock — unless it’s called away. It’s essential to recognize that any capital gains derived from holding the stock are capped at the strike price.

Conversely: The option buyer, the individual who agreed to purchase your option, may also covet the dividend. As the ex-dividend date looms, the likelihood of your stock being called away increases.

Key point: The option buyer, or holder, possesses the right to call the stock away at any time. While you still retain the premium and any capital gains up to the strike price, the risk lies in potentially missing out on the dividend if the stock departs from your account before the ex-dividend date.

Another key point: Some option buyers may exercise the call option ahead of the ex-dividend date to secure the dividend for themselves. Moreover, if the option is deeply in the money (ITM), there’s an elevated probability that the stock will be called away before you can collect the dividend. It’s imperative to be prepared for the possibility of the stock being called away when selling a covered call, as although you receive a premium, you relinquish control of your stock.

Remember: While early exercise remains a possibility at any time, the probability increases as the stock’s ex-dividend date approaches.

Get potential tax advantages by selling covered calls

Selling covered calls within an individual retirement account (IRA) or other retirement accounts may offer tax advantages, as premiums, capital gains, and dividends could be tax-deferred. However, it’s crucial to note that there are exceptions, and consulting with a tax professional to assess your specific circumstances is advisable.

In the case of holding stock in a taxable brokerage account, various tax considerations come into play.

For instance, suppose you find yourself with potential profits on XYZ stock in November, but for tax-related reasons, selling is not desirable. In such a scenario, you can write a covered call that is presently in the money (ITM) with a January expiration date. If the plan unfolds as anticipated, the stock will be sold at the strike price in January, marking the commencement of a new tax year. It’s important to bear in mind that, regardless of how minimal, there is always a risk that your option may be assigned sooner than planned.

Conversely: If the stock depreciates instead of appreciating, you are likely to still hold the stock, and the call option will expire without value. At this point, you have the option to sell the stock or consider selling another covered call. However, it’s crucial to acknowledge that the underlying stock may not rebound and reach your strike price.

Key point: Weigh the benefits against the risks when deciding whether to sell covered calls. If you determine that the advantages outweigh the risks, you may identify stocks deemed suitable for covered call writing. The buy-write strategy enables you to simultaneously acquire the underlying stock and sell (write) a covered call.

Remember: You may be subject to two commissions — one for the stock purchase and another for writing the call. Even seemingly straightforward options strategies like covered calls necessitate education, research, and practice. It’s essential to remember that no options strategy is universally suitable unless it aligns with your investment goals and risk tolerance.

• Vladimir Krull