When we write covered calls one way of doing it is to sell out-of-the-money (OTM) call options over purchased stocks or futures. The normal manner in which this is done, is to own a specific number of shares equivalent to the number of option contracts you will sell. For example, since one option contract in the USA cover 100 shares, you might purchase 1,000 shares and sell 10 call option contracts at exercise prices above the share price on date of purchase.
The premium you receive when you write covered calls OTM is designed to offset any capital losses should the share price fall after purchase. In such cases, you can buy them back cheaply, then sell more calls at a lower exercise price, bringing in more premium. But you'll also have less capital gain on the shares should the price recover.
To illustrate, let's take a look at Cisco Systems shares (CSCO). As at the date of writing, Cisco shares closed at $17.60. We look at a chart and notice an "inverted head and shoulder" pattern, which signals a possible impending price reversal.
So we buy 1,000 shares at $17.60 and sell 10 call option contracts at $19 exercise price and 39 days to expiration. Leaving out future adjustments, our risk graph would look something like this:
Our maximum profit at expiration is $1,630
Now let's consider a more aggressive way to write covered calls, but this time with much more profit potential without sacrificing risk.
Here's what we do:
1. Purchase 1,000 CSCO shares at $17.60
2. Purchase 10 x $18 Call Option contracts with 39 days to expiration, for $0.54 per contract
3. Sell 20 $19 Call Option contracts with same expiration period, for $0.23 each = $0.46 total.
You'll notice that the premium received from selling twice the amount of calls than we bought, gives us an almost zero cost for the options positions. Ideally, placing this part of the trade for even money would be a better alternative, but this should do to illustrate the point for our purpose here. Look out for higher implied volatility in the OTM options if possible, for even money trades.
Now let's take a look at the revised risk graph.
When we write covered calls using this more aggressive strategy, our maximum profit increases from $1,630 to $2,320. The extra 10 sold contracts are "covered" by the 10 bought contracts at a lower strike price, so there are no extra margin requirements.
Our more aggressive covered call strategy includes slightly more risk, since we don't have any premium to offset a fall in share price. But then again, should the price fall instead of the anticipated rise, we now have twice as many already $19 "sold" options that we can now buy back for next to nothing and then sell more call options for the lower $18 strike price, thus making a profit.
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