Transcription
I want to welcome you to this video on options trading for beginners. Today, I'm teaching you about covered calls. I'm going to explain to you why stock market investors love covered calls, and then I'm going to show you how to do it. If you think that covered calls are complicated, they're not. I'm going to break it down for you nice and easy, and then you're going to become a much better investor in the stock markets. I just want to say that personally, I'm a big fan of covered calls because it gives me a steady stream of income.
Before we begin, I want to tell you this to help you out: if you don't have a solid understanding of call options, then please watch my other video on call options before watching this one. Otherwise, this video is going to seem complicated to you, but it's not—not after you watch the other video. So, I'm going to leave a link for you down below. I think that you're really going to like that video, and it's going to be so helpful to you.
Now, let me tell you the good and the bad of covered calls. The good thing about a covered call is that you will be paid income. Now, this could be weekly income, it could be monthly income, or annual income—it's your choice. You get to decide. You make money by selling the call option. I want to be very clear about this: in this scenario, you cannot lose money by selling the call option. You could lose money on your stock, but you cannot lose money on the sale of the call option. It is guaranteed money. Even if you're a beginner, you will make money by selling the call option.
But there's a trade-off. The bad thing is that when you sell the call option, you are limiting your upside potential if your stock goes up. So don't worry; I'm going to draw this out for you. I'm going to be very clear about this, and I'm going to show you the math. In the last video that I made, you were the buyer of the call option. In this video, we're doing it from the perspective where you are the seller of the call option. There are three scenarios where you sell call options:
Scenario number one: you buy a call option and then you sell it. That is not what this video is about.
Scenario number two: you sell a call option. In this situation, you are shorting the call option. That's not what this video is about.
Scenario number three: you buy a stock and then you sell the call option. This is a covered call, and this is what this video is about.
So let me explain to you a covered call and how you make guaranteed income. We're going to use a real-life example—a real stock, the real price, and the real call option prices. I thought that this would be best because I want to show you that this entire conversation is legit. We're going to be dealing with Intel stock, ticker symbol INTC. At the time of making this video, Intel is at thirty-two dollars a share—a little bit over, but we'll call it 32 to make it easy. We're going to use the Intel call option that expires in about two months, and that call option with a thirty-four dollar strike price is selling for one dollar and fifty cents.
So again, what I'm showing you is a real-life example, so these are actual numbers. Keep that in mind; that's important because you're going to see how much money you can make, and it gets kind of wild.
Okay, so here's the situation: let's say that you buy Intel at 32. I give you an offer. So I, Brian, want the option to buy Intel from you at 34 within the next two months. If you're going to give me that option, then you're not going to give me that option for free. So you're going to tell me, "Okay, Brian, if you want that option, then it's going to cost you a dollar fifty." I tell you, "Okay, you got yourself a deal. Let's do it." So I pay you a dollar fifty to have that option to buy Intel from you at thirty-four dollars within the next two months.
In other words, you sold me a thirty-four dollar call option that expires in two months for a dollar fifty. Okay, so why would I do this? Why would you do this? Let's work out four scenarios, and I'll show you the math.
Scenario number one: the share price of Intel goes down. You bought Intel at 32 a share, and let's say that in two months, Intel falls in price by two dollars. It goes from thirty-two dollars to thirty. In this scenario, I'm not going to use the call option that you sold me because why would I buy Intel from you at 34 when I could just buy it on the open market for 30? So in this scenario, you sold me a contract that turned out to be worthless for me.
Okay, so for you, Intel falls from 32 to 30. You lose two dollars on the stock, right? But you made a dollar fifty by selling me the call option, so you hedged, and you're only down 50 cents instead of two dollars. So it's a good thing that, well, in this scenario, that you sold me the call option.
Moving on to scenario number two: the share price of Intel does nothing. You bought Intel at 32, and after two months, it's the same—nothing happened; it's still at 32. In this scenario, you didn't make money; you didn't lose money on the stock. The price stayed the same, but you sold me the call option to buy Intel from you at 34. I paid you a dollar fifty to have that option, but I'm not going to exercise that option because I'm not going to buy Intel from you at 34 when I could just buy it on the open market for 32.
So in this scenario, congratulations to you! Your stock did nothing, and you made a dollar fifty. Let me tell you, making a dollar fifty in this type of transaction in two months is not bad because a dollar fifty divided by 32, which is what you paid for Intel, that's a gain of 4.6 percent. So you made a gain of 4.6 percent in two months. If you annualize that, that's a rate of return of 28 percent. And again, these are real numbers, so this is how awesome options are, and the results get even better in the next scenario.
So I'm going to show you scenario number three: Intel goes up by a little. You bought Intel at 32. Let's say Intel goes up from 32 to 33. In this scenario, you made money on the stock because Intel went up from 32 to 33. Additionally, you sold me the call option to buy Intel from you at 34. But the share price of Intel is at 33, so I'm not going to exercise my option because even though the stock price went up, I would rather buy Intel in the open market for 33 rather than buy it from you for 34.
So this is an awesome scenario for you because you made a dollar fifty by selling me the call option, and your stock went up by a dollar. So you're up two dollars and fifty cents in two months. That's a 7.8 percent gain in two months. Annualized, that's a rate of return of 46.8 percent.
Scenario number four: the price of Intel shoots up. You bought Intel at 32, and Intel shoots up, let's just say, from 32 to 40. So you have to remember that you sold me the option to buy Intel from you at 34 within the next two months, and it shot up to 40. So you know what I'm going to do? You know what I'm going to do with the call option that you sold me? I'm going to use it. I'm going to exercise it. I'm going to buy Intel from you at 34, and I'm going to sell it on the open market for 40.
So even though the price of Intel shot up to 40, you are forced to sell it to me for 34. So that was the contract; that was the deal. I paid you a dollar fifty for that option. So you bought Intel at 32, you sell it to me for 34, so you make two dollars of gain on the stock, and I paid you a dollar fifty to buy that call option from you, so you make a dollar fifty there. You walk away with a gain of 3.50 in total. That's an 11 percent gain in two months. Annualized, that's a rate of return of 66 percent. That's pretty awesome!
Now, with that being said, I want to ask you a question, and just think about this honestly: would you be upset if this happened to you? Because you made an 11 percent gain in two months, but if you never sold the call option, then your stock would have gone up from 32 to 40, and you would have an eight-dollar gain on the stock. But you did a covered call, and you made a total gain of 3.50. So you sold yourself short. You still made money, but you would have made more money if you never sold me the call option. But of course, you didn't expect the share price to go up so high so quickly. So I guess it's just a matter of your point of view whether you'd be kicking yourself or not over the situation. But that is the risk of writing a covered call. Again, you cannot lose money by selling the call option; the downside is that you are limiting your upside potential.
Okay, so I hope that you're still following along. I hope that this is all clicking, but I have to show you two very important variables with covered calls: the strike price and the duration. But first, if you're finding this helpful, please give this video a thumbs up. I'm just trying to be helpful. If you can help me with a like, I'd appreciate it so much, and thank you very much. I appreciate it.
Now, let's modify the variables and see how the numbers work out. Let's change the duration of the contract, which is the expiration dates of the call option. So the 34 call option two months out is selling for one dollar and fifty cents, but what if we changed the duration to six months out? Now, I want you to know this: the more time the call option has, the more expensive the call option will be, and that means that you, as the seller, would collect more money.
So let's look at the call options on Intel six months out instead of two months, and here are the prices for the call options six months out. As you can see, the 34 call option six months out is selling for two dollars and sixty-one cents. So if you sell that call option, then you would receive two dollars and sixty-one cents. But here's the thing: you may be thinking, "Okay, but you can sell the 34 call option two months out and make a dollar fifty." So over the next six months, why not just sell the 34 call option for a dollar fifty every two months? That way, you'll make a dollar fifty, a dollar fifty, a dollar fifty, and then after six months, you'll end up with four dollars and fifty cents. So that sounds better than selling a single call option six months out and making two dollars and sixty-one cents, right?
So that would be true if two months from now the thirty-four dollar call option were still selling for the same price at a dollar fifty, and then two months after that, if the call option was still selling for a dollar fifty. So in that scenario, yes, you would make more money by selling a two-month option and then another two-month option and then another two-month option instead of selling a six-month option. However, the price of the call option is constantly changing. If the stock price of Intel falls from 32 to 28, the 34 call option two months out would probably sell for around 50 cents or even less.
So that's the risk that you're taking by going with a shorter call option. If you lock yourself into a longer call option, then you know how much you're going to make in six months. If you go with shorter time frames, then you don't know how much the 34 call option will be selling for when the time comes. You may get a better price; you may get a worse price. So that's the risk.
Now, let's change another variable: let's change the strike price. So you can sell the 34 call option two months out and make a dollar fifty, or we can change the strike price to 38 and sell that option for 50 cents. If you go with a higher strike price, then you're giving yourself more upside potential to make money on the stock in the event that your stock goes up.
So just think about it: you're guaranteed 50 cents in two months' time. If Intel shoots up to 38, sure, you're going to make less money by selling the call option because you're only going to make 50 cents instead of a dollar fifty, but you're going to make more money from the stock going up because if Intel shoots up to 38, you're going to be forced to sell Intel at 38. But if you sold the 34 call option, then you would be forced to sell Intel at 34.
But you probably realize the downside: if you bought Intel at 32 and it did a whole bunch of nothing, let's just say that after two months, it stayed at 32. Well, if you sold the 34 call option, then you could have made a dollar fifty. Instead, if you sell the 38 call option, then you're only going to make 50 cents. So that's the dilemma.
For the call option, the closer the strike price is to the current price, the more expensive the call option becomes. The farther the strike price, the cheaper it becomes.
Okay, now let me show you how to write a covered call. In order to write a covered call, you need to buy the stock first and then sell the call option. So do not buy a crappy stock because you don't want to make money by selling the call options but lose money on the stock. So that's like dropping quarters to pick up pennies. Find a good stock that you think will go up.
If you remember from my previous video on options, you're dealing with 100 share increments. So in this Intel example, in order to do a covered call, you need to buy 100 shares of Intel first, and then you sell the call option. So let's just say that you already own 100 shares of Intel. In this scenario, you would just place a single order: sell to open one contract, select the expiration dates and the strike price, the price of the option, and that's it. Piece of cake—very easy!
If you have 500 shares of Intel and you want to write covered calls on all 500 shares, then it's going to look like this: sell five call options. Just so you know, you don't have to write covered calls on all your stock. If you have 500 shares of Intel, you can write one contract, you can write three contracts—whatever you want. And you're going to notice that it says 750; that's how much money you're going to make from selling five covered calls.
So here's the math: the 34 call option is selling for a dollar fifty, so that's a dollar fifty a share. Multiply that by 100 shares, and that's 150 for each call option contract. Multiply that by five call options that you're selling, and you make 750. One hundred fifty a contract times five contracts equals 750.
As I said to you before, you need to buy the stock first and then sell the call option. But I want you to know that many brokerage accounts will allow you to buy the stock and sell the call option at the same time, so it'll be simultaneous. So it would look like this: you're completing two actions at the same time—buy the stock, sell the option.
Now let me finish by telling you what happens after you write the covered call. As soon as you sell the call option, you receive that money immediately. So if you sold the thirty-four dollar call option two months out for a dollar fifty, which would equate to 150, then you would receive that 150 in your account immediately. So it's automatic; it's going to appear in your account. It's going to appear there like magic, so you don't have to do anything.
Now, after two months, let's say the price of Intel ends up at 35, which is above your thirty-four dollar strike price. Then you would be forced to sell your Intel stock at 34, and your Intel shares would be sold automatically. You don't have to do anything; they take care of it for you. If the price of Intel ends up below 34, then the call option that you sold expires worthless, and it's automatically eliminated. So you don't need to do anything; your brokerage account takes care of everything for you.
You have to remember that you got paid up front for selling the call option. Now, I want to give you these last tips: the premium is a fancy way to say the price of the options contract. So if the 34 call option is selling for a dollar fifty, then a dollar fifty would be the premium. If you're selling the option, the more premium, the better, because as the seller, you want to get paid more money for writing the contract.
In terms of how options are priced, I want to explain this to you in a nutshell: more time on the contract means more premium; the closer to the strike price means more premium; the more volatile a stock is means more premium. So regarding volatility, this makes sense because just think about it: if a stock is going up or down like crazy, then you deserve to be compensated more for locking yourself into a contract at a certain price because who knows what's going to happen to the stock within your duration.
So when you're looking to write covered calls, make sure that the deal makes sense because you have to remember the downside is that you're limiting your upside potential during the contract's duration. So if the risk is not worth the reward, then don't do it. I know that the appeal of guaranteed income is great, but if it's not worth it, just don't do it. Use your best judgment; I trust you.
If you want to find good covered calls, it's like shopping. You have to shop around for good deals. Sometimes there won't be any good deals; other times, there will be a lot of good deals. So usually, there are a lot of good deals on a lot of good stocks. Just use your best judgment, and you'll get the hang of it.
Now, I want to end with this: please check out our website. I'm always on the hunt for good covered calls and good options contracts. We post about them; we chat about them. Again, I love covered calls, and then I'll leave a link for you down below. Please subscribe. I thank you for the support, and I wish you a very nice day. Take care and happy investing!