Letter from Kirk
Covered calls are the proverbial “bridge” which many traditional stock investors
cross into the world of options trading. The gateway or door to a new paradigm
of investing that, when used correctly, offers higher returns and less risk. Yet,
most investors are scared away before they even take the rst step
We are taught by traditional media, schooling, and decades of conditioning that
the only way to invest and build wealth is via stocks. That you cannot beat the
market so why try? But, what if that wasn’t actually true? Wouldn’t you have a
moral obligation to change the way you invest if we proved that you could beat
the market? We think so
The goal of is this book is to help educate you on how options trading, in
particular covered calls, can help transform the way you build wealth and invest
your hard-earned money. You see, options trading isn’t new; it just might be new
to you. All you need is someone to hold your hand and help you walk across the
bridge
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There’s a completely new world waiting for you and I’d love to be your guide as
you start, or continue, this journey. Let’s get started…
Reproduction and distribution of this report, in any form, partial or full, of its content herein via, including but not
limited to email, social media, download, hard-copy, screenshot, image, etc. is strictly prohibited without advanced and
express written consent by Option Alpha LLC. Any individual, company, and/or entity found in breach of this
agreement will be subject to all legal remedies available at law, including litigation.
Option Alpha™ is the copyright and trademark holder of all branded properties for Option Alpha, LLC and Alta5 Inc., and Kirk N. Du Plessis. Neither the Option Alpha, LLC
and Alta5, Inc., Kirk N. Du Plessis, or any of its af liates, owners, managers, employees, shareholders, of cers, directors, other personnel, representatives, agents or
independent contractors (herein referred to as the “Company”) is, in such capacities, a licensed nancial advisor, registered investment advisor, registered broker-dealer or
FINRA | SIPC | NFA-member rm. Examples presented on Company’s website including video tutorials, indicators, strategies, columns, articles, emails, reports,
downloads, and all other content of Company’s products (collectively, the “Information”) are provided for informational and educational purposes only. Such set-ups are not
solicitations of any kind or order to buy or sell a nancial security and should not be construed as investment advice under any circumstances.
The Company will not be held liable for losses resulting from information or advice presented in this information (or from a third party); the use of such information is
entirely at the risk of the user. The Company assumes no responsibility or liability for your trading and investment results whatsoever under any circumstances. The sole
and exclusive maximum liability to the Company for any damages or losses shall solely be dissatisfaction to the user. The risk of loss in trading securities, options, stocks,
futures and forex can be substantial. Securities involve risk and are not suitable for all investors. Consider all relevant risk factors, including your personal nancial
situation, before trading. Past results of any individual or trading system published by the Company are not indicative of future returns. It should not be assumed that the
methods, techniques, or indicators presented in these products and services will be pro table or that they will not result in losses. Backtesting provides a hypothetical
calculation of how a security or portfolio of securities, subject to a trading strategy, would have performed over a historical time period. You should not assume that
backtesting of a trading strategy will provide any indication of how your portfolio of securities, or a new portfolio of securities, might perform over time. You should choose
your own trading strategies based on your particular objectives and risk tolerances. Be sure to review your decisions periodically to make sure they are still consistent with
your goals. Past performance is no guarantee of future results that may be assumed from this report and its ndings.
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YOU EXPRESSLY UNDERSTAND AND AGREE THAT THE COMPANY SHALL NOT BE LIABLE TO YOU FOR ANY DIRECT, INDIRECT, INCIDENTAL, SPECIAL,
CONSEQUENTIAL OR EXEMPLARY DAMAGES, INCLUDING BUT NOT LIMITED TO, DAMAGES FOR LOSS OF PROFITS, GOODWILL, USE, DATA OR OTHER
INTANGIBLE LOSSES (EVEN IF THE COMPANY HAS BEEN ADVISED OF THE POSSIBILITY OF SUCH DAMAGES), RESULTING FROM: (I) THE USE OR THE
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Table of Contents
1) Options Basics
5
2) Covered Calls
20
3) Strategy Setup
29
4) Position Management
43
5) Synthetic Strategies
52
Chapter One
Options Basics
Whether you're an experienced options trader or
a newbie, it's easy to jump into this guide with
both feet and dig right into the covered call
strategy
If you're the latter, let's rst make sure you have a little
background info on options trading jargon, or you might
quickly get confused. As such, we thought it would be good
to go over a bunch of essential "options basics" together,
including options speci c terminology. If you're already an
experienced investor and familiar with options, feel free to
skip right ahead to Chapter 2. If not, then you'll enjoy the
newfound jargon, which is unique to options trading
NOTE: We'll often refer to the stock shares as the underlying
stock or underlying shares. The term "underlying" is speci c
to the world of options trading. It references the stock shares
that serve as the base, or basis, for the options contract,
which is created on top of the shares. Since options contracts
derive their value from the stock shares, we use the word
"underlying" to describe the logical hierarchy of the option
contract. The option contract is built on top of the stock;
therefore, the stock shares are underlying to the option
contract
Expiration Date
Options Contract
Options expiration is the date when the option contract for
the underlying stock expires or is terminated. It's the point at
which the option buyer ultimately has to decide to convert, or
what is commonly referred to as "exercise," their option
contract into shares of stock. Most optionable stocks have a
wide variety of expiration dates. These include weekly
expirations, monthly expirations, and quarterly expirations
An options contract is simply an agreement between two
parties for the sale or purchase of an underlying stock at a
pre-determined price in the future. Each option trade requires
an option seller and an option buyer. Typically, one option
contract controls or leverages 100 shares of the underlying
For example, you might enter into a contract that expires in
30 days or 90 days from today. As the name suggests, the
expiration date for options contracts can vary in the future so
that both option buyers and sellers can appropriately match
their desired timeline and exposure. As a general rule, the
In either case, it's always good to go through the basics and
make sure you understand the foundational elements before
moving forward. So, try not to skip this section. Please take
the time now to develop, or refresh, your basic options
trading knowledge
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stock. Option contracts include four additional elements; an
expiration date, strike price, option premiums, and are
classi ed as either calls or puts
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further out in time the expiration date is, the more valuable
the option contract compared to a shorter expiration date
contracts
Strike Price
In any option contract, the two parties (option buyer and the
option seller) need to agree on the price at which they are
mutually comfortable, either buying or selling stock in the
future. This future price is called the strike price. It is called
this because it is the price at which they "strike a deal" on
agreeing to exchange underlying shares regardless of the
market value of the shares at the time of expiration. The
strike price can vary greatly and range in prices below or
above the current underlying stock price
For example, let's assume that shares of stock for a
company are trading at $95 per share. You could trade an
option contract with a strike price of $105, effectively $10
above the current market price, or with a strike price of $80,
effectively $15 below the current market price. Strikes prices
can have increments as low as $0.50 to as wide as $50
Option Premiums
As you might expect, there's no free lunch when trading
options and all option contracts require a premium to be paid
by the option buyer to the option seller to complete the
transaction. The buyer always pays the premium, and the
seller always receives it no matter what type of option you
For example, you might see an option contract price quoted
as $1.45 on your broker platform. This means that the
contract's value is $1.45 for each share, and since the
standard contract multiplier is for one contract is to leverage
or control 100 shares, the actual real value of the contract in
total dollars is $145. Likewise, an option contract quoted at
$0.37 is worth $37 total dollars and an option contract quoted
at $4.78 is worth $478 total dollars. Option premiums change
frequently and are determined by two main factors; intrinsic
value and extrinsic value, which we'll cover in more detail in
an upcoming section
Call & Put Options
There are only two classi cations, or types, of options
contracts; call options and put options. Since you can choose
to be either an option buyer or seller of calls and puts, we
want to rst walk through the rights and obligations of each
scenario. As a general rule, buyers of options have rights,
and sellers have obligations. Keep this quick rule in mind as
we move forward
Call options give the option buyer the right, but not the
obligation, to purchase the stock at the strike price at
expiration. And because the choice to buy stock, or not, in
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are trading, whether call options or put options, which are
discussed next. Option prices are quoted in dollars per share
for simplicity, but more often, this creates a little confusion for
traders
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the future is valuable, call option buyers pay an option
premium in exchange for this right to choose. Alternatively,
the premium paid by the option buyer goes to the call option
seller, which now has an obligation to sell the stock at the
strike price at expiration, or before, if the option buyer
exercises or enforces their contract
Put options give the option buyer the right, but not the
obligation, to sell the stock at the strike price at expiration.
Just like call options, this choice to sell the stock, or not, in
the future is valuable. Therefore, put option buyers pay an
option premium in exchange for this right to choose. The
premium paid by the option buyer goes to the put option
seller, which now has an obligation to buy the stock at the
strike price at expiration, or before, if the option buyer
exercises or enforces their contract
Exercise & Assignment
Now that we've covered the four main elements of an options
contract lets quickly discuss the logistics of how exercise and
assignment work. Exercise and assignment are the
processes by which options contracts are converted to
underlying shares. Oddly enough, it's effectively the same
transaction happening but commonly called two different
names depending on which side of the contract you are on
initially; buyer or seller
The question you should be asking at this point is, "When
would an option buyer exercise their contract?" The option
buyer would only choose to exercise their contract and buy/
sell shares at the strike price if it's nancially pro table for
them to do so before or at expiration. Again, pretty simple
when you think about it logically
If exercising their contract would create a larger loss than the
value of the option premium paid to enter into the agreement,
then the option buyer would simply let their contract expire
worthless. In this case, the option seller would keep the
entire premium collected at the beginning of the transaction
as a pro t
Option Contract Examples
Alright, we've hit you over the head with enough terminology
and de nitions for now. If things are getting a little fuzzy and
blurred, we're going to bring all of these concepts together
with a few examples. In each example, we'll highlight the
option contract details and walk through the speci cs of what
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As a reminder from a couple paragraphs back, option buyers
have the right, but not the obligation, to exercise (convert) the
option contract into underlying stock. Therefore, the option
buyer is always the one who could exercise their contract,
and the option seller is always the one who gets assigned an
options contract. It's as simple as that. Buyers exercise,
sellers are assigned
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might happen at expiration for different stock price scenarios.
Let’s dive in
math analysis shows that it would be nancially unwise to do
so
Example #1: Call Option
If you were to exercise your call option, you would purchase
the stock at $57 per share (strike price) when it's only worth
$43 per share in the open market. Not a smart investment, so
your best choice is to simply let the option contract expire
and lose the $3 premium you paid to the option seller. Losing
$3 is better than losing $17 per share, the $3 premium paid
to the option seller plus the negative value of $14 from
potentially buying shares at $57 when they are only worth
$43
Here's the setup for this option contract:
1. Underlying stock is trading at $50 per share
2. You purchase a call option contract
3. The expiration date is 60 days from today
4. The strike price for your option contract is $57
5. You pay an option premium of $3
As a call option buyer, you now have the right, but not the
obligation to purchase the stock for $57 per share anytime in
the next 60 days. After 60 days, your contract expires, and
you no longer have this right. The call option seller, on the
other side of the trade from you, has an obligation to sell
shares to you at $57 if you choose to exercise your contract.
Let's walk through a couple of different expiration scenarios
together. Remember that as the option buyer, you’re in
control of the choice to exercise the contract or not
Call Scenario 1: Stock closes @ $43 per shar
At expiration, it seems the stock moved lower from $50 to
$43. In this scenario, the best decision would be not to
exercise your call option contract. Why? Well, some simple
Call Scenario 2: Stock closes @ $57 per shar
The stock rose dramatically in value, and right to your strike
price of $57, which is what you might have expected as a call
option buyer. Kudos to you for picking the right direction. But,
unfortunately, the stock didn't move far enough as you would
also not exercise your call option contract in this scenario
and simply let it expire worthless. "But wait, Kirk, the stock
moved exactly where I wanted right?" Yes and no
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It should be noticeable at this point that call option buyers
want the stock to rise signi cantly in value in the future. But
how far does the stock need to rise to make it worth it for the
call option buyer to convert the option and exercise the
contract? Let's look at another scenario
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Recall that you paid an option premium of $3 to the call
option seller to enter into this option trade. This option
premium is a cost of doing business and cannot be swept
under the rug. We need to account for it somewhere. So,
what we do in a call option scenario is add the option
premium to the strike price of the contract to get your
effective “all-in-cost" of stock ownership. In our working
example, this break-even or “all-in-cost" is $60 per share; the
$57 strike price plus $3 option premium paid
With the stock trading at $57, there's no nancial bene t to
exercising the contract as you could just as easily purchase
shares in the open market for the same price. Therefore,
your best decision is again just to let the call option expire
worthless. The option seller would still keep the entire $3
premium as pro t at expiration
In this scenario, we've learned a vital new piece of
information. That the actual expected price for the stock or
break-even point, to make it pro table overall for the call
option buyer, needs to be at a price per share that is above
the strike price plus the value of the option premium paid
As you might expect having coming this far in the scenarios,
purchasing call options requires both a signi cant move in
the underlying stock and in the right direction to be pro table.
Both of which are hard to predict or estimate consistently for
the option buyer. What about put options though
Example #2: Put Option
Here's the setup for this option contract:
Congratulations, the stock made a huge move, much higher
and well above your call option break-even point of $60 we
just calculated in the last scenario. At expiration, the best
decision would now be to exercise your call option contact.
1. Underlying stock is trading at $50 per share
2. You purchase a put option contract
3. The expiration date is 30 days from today
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Even after paying the $3 premium to the call option seller 60
days ago and purchasing the stock at the strike price of $57,
you could sell the shares immediately in the open market for
$65 per share resulting in a $5 pro t per share overall. The
call option seller, in this case, would be obligated to purchase
shares in the open market for $65, if they didn't own them
already, and sell them back to you at $57 (strike price) for an
$8 net loss per share on the stock. Don’t forget however, they
collected an upfront premium of $3 from you, the option
buyer, which reduces their overall net loss to just $5 per
share
Call Scenario 3: Stock closes @ $65 per shar
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As always, the math works, or it doesn't, and in this scenario,
it is nancially pro table to exercise your call option
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4. The strike price for your option contract is $45
successfully, your pro t is the difference between where you
sold shares and where you purchased shares
5. You pay an option premium to the seller of $2
As a put option buyer this time, you now have the right, but
not the obligation to sell the stock for $45 per share anytime
in the next 30 days. After 30 days, your contract expires, and
you no longer have this right. The put option seller has an
obligation to buy shares from you at $45 if you choose to
exercise your contract
But why would you want to sell the stock when you don't
even own it in the rst place? What nancial bene t is there
in this type of trade for you? The concept seems
counterintuitive, but it's not. You see, most investors are used
to a single avenue for generating pro ts. They buy the stock
at a low price and look to sell back the stock later on at a
higher price. Buy low, sell high
Few investors realize, however, that you can use these same
buy and sell orders just in reverse to pro t from a stock
moving lower. When you reverse the order of buying and
selling, its called "shorting a stock," and you pro t from a
decline in the underlying share price. Sell high, buy low
It works like this. You borrow stock from your broker to sell to
someone else in the open market. You're betting on the stock
moving lower and hope to purchase shares at a lower price
later on to ful ll the trading loop and deliver the shares back
to the broker that you borrowed. When you do this
The stock went up before expiration, but now that you are a
put option buyer, this is terrible news for you. At expiration
you would choose not to exercise your put option contract.
Why? Well, if you were to exercise your put option, you
would sell shares of stock at $45, the strike price, but would
have to buy shares at the prevailing market price of $52 to
complete the trading loop
If in this scenario, we are selling shares at $45 and being
forced to buy them in the open market at $52, it's not a smart
investment decision. Your best choice is to simply let the put
option contract expire and lose the $2 premium you paid to
the option seller. Losing $2 is better than losing $9, the $2
premium paid to the option seller plus the negative value of
$7 from potentially buying shares at $52, and selling them for
$45
Notice how these put options are starting to behave just like
the call option scenarios, only in reverse? Put option buyers
want the stock to fall in value in the future, similar to the
expectations of someone shorting the stock. I'm sure you can
see where this is going based on the prior option examples,
but let's walk through some more scenarios just in case it's
not 100% clear
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Put Scenario 1: Stock closes @ $52 per shar
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Put Scenario 2: Stock closes @ $45 per shar
The stock fell in value, as you might have expected, but still
not far enough to reach your break-even point. At $45, there
is no nancial bene t exercising your put option contract with
the option seller. You could just as quickly buy shares at $45
in the open market and sell them back to the put option seller
for $45, which is essentially a wash
Recall that you also paid an option premium of $2 to the put
option seller. When we subtract this from the strike price,
your effective break-even target for the stock is $43, the $45
strike price minus $2 option premium paid. So, the best
choice again is to let the put option expire worthless and lose
the entire $2 premium paid to the put option seller
For put options, we've now learned that in order for you to
make money as an option buyer, you need the stock to trade
low enough so that selling the stock at $45 creates a net
pro t after paying the option premium. This expected price
for the stock or break-even point is calculated as the strike
price minus the value of the option premium paid, $43 in our
example
Put Scenario 3: Stock closes @ $40 per shar
The stock closed well below your put option break-even point
of $43. Things are not looking good for the stock, and it's
falling hard, but as a put option buyer, this is excellent news
for you. At expiration, you would choose to exercise your put
The put option seller, in this scenario, would be obligated to
buy shares at the strike price of $45 from you, when they are
valued in the open market at $40 per share for a net loss on
the shares of $5 per share. However, they collected an
upfront premium of $2 from you, the option buyer, which
reduces their overall net loss to just $3
As we witnessed with the rst call option example,
purchasing put options requires both a signi cant move in the
underlying stock and the right direction. It's tough to predict
or estimate consistently how far a stock will drop and in what
timeframe. There has to be a better way right? There is, and
we'll get there soon
Reversing Trades
We've talked a lot so far about buying and selling shares at
expiration with options contracts. However, you should
understand that exercise and assignment of physical shares,
as described in the pages above, are rare. The reality is that
most options contracts are closed well before expiration by
merely reversing the initial trade. Doing so doesn't impact the
outcomes or change the decisions you make, but rather
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option. Even after paying the $2 premium to the put option
seller and purchasing stock in the open market for $40, you
could sell the shares immediately back to the put option
seller at the strike price of $45 per share resulting in a $3
pro t per share overall
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opens up the possibility to exit or adjust positions before
expiration if you deem necessary.
For example, let's assume you purchased an options
contract, call or put, with 30 days until expiration. You don't
have to hold it until expiration unless you choose to do so.
You could choose to quickly reverse your trade and sell the
contract to someone else, which closes your position.
Likewise, if you sold an option contract to an option buyer,
again call or put, you could buy back the contract from
someone else and close the position, thereby removing your
obligation to deal with the stock at expiration
Statistically speaking, at Option Alpha we've only ever had to
deal with the assignment of physical stock less than 1% of
the time in the last 10+ years of trading options. It's
something manageable and won't ever harm you so long as
you are controlling your position size. We will explore this
topic in more detail during a later chapter, but be aware that it
is not an automatic assumption of exercise and assignment,
and people worry about it way more than is necessary
In the end, we hope that the examples we just went through
added a lot more clarity to the relationship between option
buyers and sellers and how or when options contracts could
increase or lose value at expiration. In the next sections, we'll
dig much deeper into the factors and inputs on how option
premiums derive their value. The goal is for you to
understand how different market environments or situations
impact an option contract's premium or price
Earlier in the description of option premiums, we mentioned
that there are two main factors by which we determine an
option's value. These are broadly categorized as intrinsic
value and extrinsic value. We'll cover each of these in detail
in the following section
Intrinsic value is the current and immediate value of the
option contract for any strike price, which is currently in-themoney (ITM). Said another way; it's the value or pro t should
the option buyer exercise their contract immediately. Call
options are said to be ITM when the strike price is below the
current stock price. Put options are said to be ITM when the
strike price is above the current stock price
For example, if a stock is currently trading at $100 per share,
a call option with a strike price of $99 would have $1 of
intrinsic value. If the call option were exercised right away,
the option buyer would be able to purchase shares at $99
and sell them in the open market for $100. Likewise, a call
option with a strike price of $95 would have $5 of intrinsic
value
On the put option side, the concept is the same, just in
reverse. A put option with a strike price of $101 would have
$1 of intrinsic value as the put buyer could sell shares at
$101 and repurchase them in the open market for $100.
Likewise, a put option with a strike price of $105 would have
$5 of intrinsic value. Simple enough, right? Great
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Intrinsic Value
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future time value of the contract based on the days remaining
from now until expiration and the implied, or expected,
volatility in the stock. We'll cover each one of these time and
volatility components individually in the paragraphs below.
For now, however, let's review a high-level options pricing
example to reinforce the general concepts of intrinsic vs.
extrinsic value components
For example, using the same stock currently trading at $100
per share from above, a call option with a strike price of $101
would be considered OTM and have no intrinsic value. The
option buyer would never willingly choose to purchase shares
at a $101 strike price when they could easily buy shares in
the open market for $100 per share. Likewise, on the put
side, if a put option buyer owned an OTM contract with a
strike price of $99, they would never willingly choose to sell
shares at $99 when they would quickly sell shares in the
open market for $100 per share
Let's assume that our same stock from before is still currently
trading at $105 per share. A call option contract with a strike
price of $100 and expiration date 30 days from now is
quoting an option premium of $6.50 per contract. Can you
gure out how much of the value is associated with intrinsic
value vs. extrinsic value? Take your time and think about it
for a minute
It should be clear by now that the intrinsic value portion of an
option contract's premium is relatively easy to calculate and
understand. The second part of an option contract's
premium, extrinsic value, is a little more complicated. Yet, it's
one of the most important aspects of option pricing you need
to understand
Extrinsic Value
There's no easy way to dissect this pricing component, so
we'll just tackle this head-on. Extrinsic value represents the
Recall that an option's price is comprised of both intrinsic and
extrinsic value. So to answer our question, its best rst to
strip out the intrinsic value which is the easiest to calculate.
The remaining portion is then merely the extrinsic value. The
intrinsic value of the contract in our example would be $5, as
this is the value of the ITM contract if the contract was
exercised today. The extrinsic value would be the remaining
$1.50 ($6.50 minus the intrinsic value of $5), which is
attributed to the value of time and volatility over the next 30
days
Now, take the same stock currently trading at $105 per
share, and let's now look at a put option contract with a strike
price of $93 and expiration date 60 days from now, which is
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Now, any strike price that is out-of-the-money (OTM), on the
other hand, would never have intrinsic value. Exercising the
option contact when OTM would offer no immediate value to
the option buyer. Call options are said to be OTM when the
strike price is above the current stock price. Put options are
said to be OTM when the strike price is below the current
stock price
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quoting a price of $0.60 per contract. Little harder right? Not
really if you slowly walk through it. Here the put option
contract has no intrinsic value as the $93 strike price is OTM,
and the put option buyer wouldn't pro t from exercising their
contract. If no value is associated with intrinsic value, then
the remaining amount is purely comprised of extrinsic value
attributed to the time and volatility until expiration
In the next section, we'll unpack the time and volatility
components of extrinsic value as we continue to dive deeper
into what impacts an option's price. Then, we'll walk through
the Option Greeks, which help us understand how an
option's price might change based on various market forces
Time Decay
The rst sub-component of extrinsic value for an options
contract is time decay. All options contracts have a nite time
until expiration, which can be a few weeks or up to a few
years from the current date. You will often hear traders
talking about 30, 60, or 90 days to expiration, and this refers
to the amount of time before the contract expires
As option contracts, both calls and puts, move nearer to their
expiration date, there is less time for them to move into a
pro table zone before they potentially expire worthless.
Hence, all contracts slowly see their extrinsic value erode
through the passage of time as they draw closer to
expiration. This erosion in value is called time decay
Time decay of an option contract speeds up so quickly that at
expiration, all that is left of the contract's value is simply the
intrinsic value, if any. This is why time decay is so crucial for
options traders because it creates a constant battle between
time and price. If the underlying stock price fails to move far
enough or fast enough, then the option contract slowly
decays under the weight of time decay
Implied Volatility
The second and most important sub-component of an option
contract's extrinsic value is implied volatility. Admittedly,
implied volatility is the edge by which option sellers, and
covered call writers, as you'll learn, gain a signi cant
advantage in the market trading. Implied volatility is the future
expectation of how far a stock will move up or down by
expiration. Since options have expiration dates in the future
and strike prices higher or lower than the current market
price for the underlying shares, it's critical that an option's
premium factor in the magnitude expectation of the stock's
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Time decay for option contracts moves at a progressively
faster pace as a contract nears its expiration date. Option
contracts further from expiration will be worth more money,
all things being equal, compared to contracts closer to their
expiration date. These further out contracts will experience
minimal impact on their price each day due to the erosion of
time decay. The nearer the contract gets to the expiration
date, the larger and more signi cant the impact time decay
will have on the contract
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price moving forward into the future. In the most basic terms,
if implied volatility is high, the stock is expected to swing
wildly in the future. If implied volatility is low, the stock is
expected to swing very little and mostly stay range-bound or
move sideways
Generally speaking, implied volatility impacts the premium of
options contracts the same for both calls and puts. When
implied volatility increases, or more simply the expectation of
future stock volatility increases, it causes an increase in the
value of both calls and puts. When implied volatility
decreases, or the expectation of future stock volatility
decreases, it causes the value of both calls and puts to go
down
Using the same example we've referenced throughout, let's
assume a stock is currently trading for $100 per share. A
$105 strike call option is quoted at $6.50 per contract. We
might also see on the option pricing table that the stock is
showing 10% implied volatility. This means market
participants expect the stock to move up or down 10%
between now and expiration. This doesn't mean it can't move
more or less; it obviously could. It just means that the
expectation right now, based on all information available and
the actions of market participants, is that the stock is
expected to trade somewhere in a 10% range up or down
“Kirk, who comes up with this number?” Funny you should
ask because you do! Well, not you in particular, but market
participants and investors, just like you determine this
So, what if the expectations for future stock volatility change?
What if implied volatility goes up to 12% from 10%?
Whatever the catalyst, market participants expect the stock
to be more volatile in the future. And as a result, start more
aggressively purchasing call options at higher prices. The call
option contract might then adjust up in value from $6.50 to
$7.50 per contract. Notice that the only change here is the
future expectation of volatility. The underlying stock price nor
the time until expiration was changed, so you can see just
how much of an impact implied volatility has on option pricing
as a single component
Option buyers might be willing to pay more money for the
options contract if they think a more signi cant move is
coming in the future. Whether that move comes or not is
another discussion altogether, which we'll cover later on. The
key concept, for now, is that traders and investors bid up and
down an option's price in relation to how far they believe or
expect a stock to move in the future
Keep in mind that the quoted implied volatility number could
be different for each stock or ETF. Some stocks might
naturally experience more volatility compared to others. An
implied volatility reading of 35% on Facebook could be a
reasonably low reading for such a large tech company. In
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number due to how aggressively or not, they purchase call
and put options. This is why it's referred to as implied
volatility because the value is "implied" by the actions of the
market participants as a whole
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contrast, an implied volatility reading of 35% for Exxon
Mobile might be very high for a large, stable oil and gas
company. It's all relative, so we use implied volatility ranking
to normalize the stocks and ETFs we monitor
Option Greeks
When setting up and monitoring positions, traders often use
or discuss option greeks. There are four main greeks,
including Delta, Gamma, Vega, and Theta. A common
misconception is that the greeks predict the future movement
and value of an option contract. It is not true. They are not
predictive but rather are simply elements that re ect what
"could" happen in pricing changes for different market
situations. Below, I'll brie y cover each one as we'll use some
of these greeks in subsequent chapters for covered calls
1) Delta
Delta measures the extent to which an option contract is
exposed to changes in the price of the underlying stock.
Delta values can range from 1 to –1 depending on the option
contract you are trading and represent the theoretical change
in an option's price following a $1 increase in the underlying
stock price
Deltas are always positive for call options and always
negative for put options. This is because a $1 increase in the
underlying stock price should always increase the value of
call options and decrease the value of put options, all else
2) Gamma
Gamma is the rate of change in an option's Delta per 1-point
move in the underlying stock's price. You can think of
Gamma as an important measure of the convexity or rate of
change of an option contract's value in relation to the
underlying continuing to move either further in one direction
or closer to expiration. Gamma risk, or the risk of large price
movements in the option contract, increases as you near
expiration
3) Vega
The option's Vega is a measure of the impact of changes in
the implied volatility on the price of the option contract.
Speci cally, the Vega of an option expresses the theoretical
change in the price of the option for every 1% change in
underlying implied volatility. Keep in mind, as we discussed
earlier, small changes in implied volatility could have
signi cant impacts on an option's price, particularly option
contracts further from their expiration date
4) Theta
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remaining constant. Delta values can also be used as a
proxy for an option contract's reaction to directional price
changes in the underlying stock shares
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The last major greek is Theta. Theta is the decay of an
option's price due to time. Theta values are always negative
for both call and put options and will always result in zerotime value at expiration. Often, traders refer to it as the "slow
drip" or "silent killer" of option buyers since it slowly erodes
positions
As expiration approaches, Theta speeds up, and the rate of
decay of the option contract accelerates as it runs out of
time. For option buyers, Theta can be death by a thousand
cuts. On the other hand, option sellers consider Theta decay
an important component for many income-based options
strategies
Conclusion
Alright - Whew! That was a lot of basics to cover, and
hopefully, you didn't skim through this chapter as there are
some golden nuggets in there you won't often nd in other
'Options Basics' write-ups online. Now that we have got
these covered, no pun intended, it's time to shift our attention
to the options strategy so very few stock traders take
advantage of, the covered call
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Chapter Two
Covered Calls
When introducing covered calls to new traders,
we're presented with a challenge: cover the stepby-step details on how to set it up or the overall
framework on "why" we use them before diving
deeper
While there's certainly no right or wrong way to go about it,
we feel that rst covering the overall framework of a covered
call seems best to set the stage for our discussion. Don't
worry if it sounds complicated at rst, we will be talking in
more detail about exactly how to set up a covered call and
how it works later on in the book. The goal here is just a
quick snapshot and overview of what a covered call is
broadly as a means to help build a more solid foundation
moving forward
What Are Covered Calls?
A covered call is an options strategy that combines the use of
long underlying stock to cover the sale of a short call option.
Yes, you are going to be selling options contracts. No, you
are not going to buy options
Traditionally speaking, a covered call strategy would require
that you already own the underlying stock or ETF shares in
your account before selling the call option. Because you are
selling a call option, this means you have the obligation, if
NOTE: Naked call selling is nothing bad at all as it requires
much less capital than a traditional covered call, mainly
because you don't have to purchase the shares of stock rst.
We don't want you to write it off, no pun intended, as it's one
of the core foundational elements of many other option
strategies that don't involve stock
Covered Call Payoff Diagra
The covered call payoff diagram is constructed on the next
page for you. The dotted blue line represents the payoff line
for long underlying shares of stock. The green dotted line
represents the payoff line for a single short call option at a
strike price near where you purchased long stock. The red
solid line shows the combined payoff when both the long
stock and short call option are combined into a covered call
strategy
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assigned by the option buyer, to deliver shares of stock at the
strike price on or before expiration. It's referred to as a
covered call because when you sell the call option, the risk of
assignment is already "covered" given that the underlying
shares are in your possession. Contrast this with a "naked"
call option in which case you have no underlying shares to
cover the risk of assignment and would have to come up with
the money if the stock went against you to cover a loss
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Who Can Trade Covered Calls
Profit
Long Stock
Los
Covered Call
Short Call
Notice that the slope of the red payoff line shifts from upward
Low Stock Pric
High Stock Price
and to the right to at and stable at the strike price of the
short call option. At this junction, the gains on the long stock
shares are directly offset by the losses on the short call
option contract. However, in exchange for capping your gains
on the stock, your break-even point or cost basis on the
shares is reduced by the amount of the premium collected.
The reduction in net cost to own the shares increase the
probability of being successful with the overall position
Visually, you can see this in the graph as the new payoff line
for the covered call strategy (red) crosses over the breakeven threshold much further to the left, which represents
lower stock prices. The stock could fall in price and you could
still make money overall
The best way to think about a covered call, in our view, is as
a strategy to pre-sell your current stock shares in the future
at a higher price. Sure, you could sell your shares and close
your position now, but what if you could pre-sell shares at a
higher price in the future and collect some income along the
way should the shares never reach that level? Sounds too
good to be true? It's not
By selling the short call option as part of a covered call
strategy, you are effectively just pre-selling your shares. More
speci cally, you are pre-selling the right to buy your shares to
someone else. Straightforward enough, right? The call option
buyer, in this case, is not obliged to purchase the shares from
you, they are just buying the right to do so if they choose,
and in exchange for this opportunity, they pay you an option
premium upfront. The price at which you feel comfortable
selling the rights to your shares is the strike price of the
contract. The money you collect upfront from the call option
buyer is the option premium or option price
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Covered calls can be traded in practically any brokerage
account type; retirement, IRA, 401k, margin, etc. Since you
already own the stock and therefore have one part of the
strategy in place, brokers allow you to sell a call option
against that stock that you own if you choose to do so. You'll
also hear this referred to as "writing" a call option which is
used interchangeably with "covered.
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Let's use a straightforward housing analogy to drive home
this concept. It would be like owning a house and signing a
contract for another person to buy your house, which you
already own (stock shares) at a predetermined price (strike
price) by a speci c date in the future (expiration date). In
exchange for you agreeing to sell them your house and
taking it off the market until expiration, they might pay you a
deposit (premium) to compensate you in case they don't
come through on their end and purchase the house
In this example, you are the owner of the underlying stock
(your house) and the call option seller. The new buyer you
sign the contract with is the call option buyer. Honestly, it's
not any more complicated than that, so let's dive a little
deeper into a covered call strategy and look at how and why
you would set one up for your portfolio. Though we brie y
mentioned it above, I want to reiterate that a key concept you
need to remember when setting up a covered call is that you
must already be long the underlying stock. Owning stock is
known as being long the stock, and without ownership of the
stock, you can't technically sell a covered call
That said, one of the signi cant bene ts new traders see with
a covered call is that you don't have the hassle of handling
the shares during an assignment. If the call option is
assigned, the broker simply takes the long stock shares from
your account that acted as collateral. We will debate the
merits of stock ownership later on in the book, but for now,
we’ll assume you do want to own a bunch of stock for some
reason or another
Why Should You Sell Covered Calls?
As great as stock ownership is, or isn't depending on who
you talk to, the question now is about the utility of doing a
covered call strategy. Why use covered calls at all? If I had to
boil it down into one main factor, the main reason for using
the covered call strategy would be cost basis reduction. Said
another way, by selling a short call option above where the
stock is trading and receiving the option premium from the
option buyer, it reduces the cost of owning the shares by the
amount of the premium
This reduction in cost basis via the premium collected, moves
the break-even point, or the net-cost, on your stock
ownership lower. You don’t have to be a rocket scientist to
know then that a lower break-even point increases your
probability of successfully generating money and income
How do you gure out the new cost basis or break-even
point? Subtract the option premium you received selling the
short call option from the initial cost of the shares you
purchased. Do this just once on a calculator, or in your head,
and you can quickly see why selling covered calls is a
pro table strategy long-term when executed repeatedly
JPM Covered Call Exampl
Let's practice with a simple example
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•
You spent $115 per share to buy 100 shares of
JPMorgan Chase (JPM) for a total cost of $11,500
•
You sell a call option with a strike price of $125, which
expires 30 days from today and receive a $5.00 option
premium ($500 of total value) from the option buyer
•
You have now reduced the cost of owning your shares
to $110 per share or a new total ownership cost of just
$11,000
Can you immediately see how powerful the strategy is for the
covered call writer, i.e., you? If the stock goes down, you've
already reduced your break-even point to $110 per share.
You still might lose money if the stock continues to move
lower, but your overall risk is reduced because of the covered
call you sold. If the stock trades sideways in a range or
anywhere below $125 (strike price), you keep the entire
premium from the call option you sold ($5.00). If the stock
rallies, then you are capping your pro t to just $15 per share,
which is the strike price of $125 less the net cost of the
shares of $110
Many investors consider this last aspect of "capping your
returns" to be one of the downsides to selling covered calls.
We would remind them, however, that if you get to the point
where the stock rallies beyond your strike price, you've still
made $15 per share in pro t in a month’s time. Are you really
going to be greedy about making money? Probably not
Think about it for a second. Do you have a higher probability
of success owning JPM stock at $110 or $115 per share?
Self-explanatory right. Plus, if you own shares in stocks
which don't pay dividends, it's an excellent alternative for
collecting income from growth-focused companies by
leveraging the power of options contracts
Now, imagine that instead of going through this process just
one time, you replicate a covered call strategy multiple times
each year, over dozens of years. Oh yes! You see, we've
only skimmed the surface because the example mentioned
above was a single covered call in a single expiration month.
Imagine if you sold a covered call through the year for
multiple years? The constant and relentless premiums you
collected would slowly chip away at your cost basis in the
underlying stock, effectively allowing you to invest in the
stock at lower and lower prices
At this point, we know that you're getting excited and
motivated to sell your rst covered call. We've been teaching
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What is so exciting to us about combining the long stock with
an option selling strategy, like a covered call, is that you now
have multiple paths to create a successful trade. It's almost
like renting out your stock shares to someone for a set time
period, i.e., until expiration, and they pay you for the privilege
of doing so. And because you've reduced your cost basis on
the shares, it turns what would be a 50/50 directional bet on
the stock into an overall strategy that has a much higher
probability of success
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this long enough to know when the light bulbs start to turn on.
Maybe you think you've found the holy grail of investing. And
while we don't want to dampen your enthusiasm, we do need
to discuss the risk involved in selling covered calls. Because
even with all the bene ts of trading covered calls, there's one
signi cant, glaring downside risk to the strategy that's always
present; the stock itself
Often in the world of investing, options trading gets bad
press, or you hear that the only way to make money is
through index investing, but it's just not the case, and the
data proves otherwise. So let us present the facts using third
party validation
It might be a hard pill to swallow for long time stock investors,
but the facts are what they are. Stock ownership is a risky
and inef cient use of capital that often overshadows all the
bene ts of executing a covered call strategy. We'll discuss in
a later chapter how you can reduce this risk using options,
but for now, we think it's important to point out that owning
shares still means that you carry all the downside risk of the
stock falling lower in a sell-off or crash scenario. While this
doesn't happen often, it doesn't mean it won't ever happen or
won't happen to you at some point. Just be conscious of the
risk
Do Covered Calls Beat The Market?
The Chicago Board Options Exchange (CBOE) put together
a set of benchmark indexes for different options strategies to
show what the result of each strategy would be when traded
against the S&P 500 Index, as well as other global
benchmark indexes such as the MSCI EAFE Index. They
included covered calls in this approach by creating the “30
Delta Buy-Write Index," which tracks the performance of
selling covered calls while also being long the S&P 500
index. The ticker symbol for the index is BXMD. Each month
the index would sell a covered call at a 30 delta strike price
against on the S&P 500 and kept doing this month after
month, year after year. The CBOE tracked performance
going back to 1986 until 2018, and these are the results
At this stage, it seems we've done as much theoretical setup
as we need, and it's time we shift our attention to some hard
data on covered calls performance. Some of you might be
cynical, rightfully so, and wondering how pro table covered
calls were compared to the overall indexes? Or if the sub-title
to the book, "1 Hour Per Month Strategy That Outperformed
The S&P 500" was just a bunch of hot air to lure you into
downloading this book
The S&P 500 annualized total return during the 32 years was
9.80%. The covered call strategy (BXMD), on the other hand,
witnessed an annualized return of 10.20%. To put this into
perspective, for every $1 invested, the S&P 500 returned
$20.85, and the covered call strategy returned $23.65. That's
more than a 13% outperformance! But that's not all; the
numbers and data get even better when you look at portfolio
variance and volatility metrics
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Covered Call Performance vs. S&P 500 (Fig. 1
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Figure 1: Value of $1 Invested - S&P 500 Return (SPX) vs. CBOE 30 Delta Buy-Write Index Return (BXMD)
$30
$25
$20
$15
$10
$5
SPX
BXMD
$0
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
2016
2018
During their research over the 32 year period, the standard
deviation, or portfolio volatility, in the S&P 500 was found to
be 14.90% with a maximum drawdown of -50.95% at any
given time. The covered call strategy (BXMD) on the other
hand, saw reduced volatility at just 12.80%, with a maximum
drawdown of -42.73%. That. Is. Crazy
created far lower volatility in your account. Isn't this what all
investors are seeking? Better returns with fewer ups and
downs in your account and more consistency? By now, it
should be abundantly clear that the covered call generated
an excess return, or Alpha, above the market benchmark,
and with lower volatility or swings in your portfolio
Not only did the covered call strategy outperform the market
by generating more money overall for the portfolio, but it also
And while this is only one of the hundreds of case studies
that prove covered calls work, it's one of the more in uential
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ones in our opinion because it was executed on the S&P
500. The very index that everyone says you can't beat, and
you should simply buy and hold, yet underperformed a
straightforward covered call strategy. The CBOE's ndings
show without a doubt that options trading, when used
correctly, can enhance your portfolio returns while also
smoothing out the volatility
minutes of your time and execute a covered call (or
something even better we'll discuss later on in the book) and
start outperforming the market with more consistency. It’s a
no-brainer
Better Covered Call Performance
NOTE: The CBOE provides the daily and monthly data for
each index and strategy for free on their website if you want
to double check the results for yourself. We included a link to
the CBOE website in the appendix to this guide, as well as
additional backtesting research we have performed here at
Option Alpha that cover a wider array of tickers and covered
call variations
As great as all the data and numbers were in this chapter, the
next logical question you should be asking is, "can we do any
better?" Yes actually! The CBOE only gives the results of two
covered call variations; a 30 delta short call (BXMD) and a 50
delta at-the-money short call (BXM) both 30 days from
expiration. But there are many more strike prices and days
until expiration for option contracts available to trade. How do
we know that the parameters the CBOE used for their
indexes are the most pro table for you
Once you get familiar with which strike prices and expiration
months to choose, you could do this in the same amount of
time it would take you to check your Facebook status or send
a text message to a friend. We said in the book sub-title that
it takes an hour to implement. We lied. It probably doesn't
take that long at all, and we are assuming you have to walk
to a library, uphill both ways, in the snow, use dial-up internet,
and move with all the lighting speed of a sloth. Instead, we
honestly believe that this strategy, once a month, could be
set up and executed in less than three minutes
Well, our research team set out on a new mission and
decided it was time to analyze the popular covered call
strategy from all angles. We spent many months of research
examining approximately 20 years' worth of data (beginning
of 1999 to mid-2019) across 109 popular underlying ticker
symbols and 5,550,676 covered call trades. We found clear
and convincing evidence that covered calls work best only
within the context of a particular set of market environments
So, do yourself and your wallet a big favor, stop checking
email or social media just one time during the month. Just
once. Give your money, your family, your future three
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Spoiler alert! Though the CBOE’s 30 Delta Buy-Write Index
(BXMD) did outperform the S&P 500, when we analyzed the
performance of a 30 Delta covered call entered 30 days from
expiration we found it to perform very poor compared to other
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covered call setups. Does this mean covered calls won’t
work? Nope; they do work. It’s just that we found more
attractive setting to use
We wrapped all the research and analysis up for you in a
beautiful report on Covered Call Performance. You can nd a
copy of this report, along with all the other backtesting
research we do at Option Alpha, on our website. Alright,
we’ve said too much already, and before we go too far down
this rabbit hole, let's continue with covered calls for now and
walk through the details on setting them up in your trading
account
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Chapter Three
Strategy Setup
Now that you understand the "why" behind
covered calls, let's talk about the actual setup
mechanics involved
There are several key steps to go through when setting up a
covered call. In this chapter, we'll review the step-by-step
process and look at a couple of covered call examples
together so that it's clear how to implement it in your account
You should rst understand that the entire process we are
going to cover takes seconds to execute and ll in the
market. The reason we bring this up now is that in our
opinion, there is no excuse for not performing this in your
brokerage account immediately after reading this book and
our performance research report mentioned at the end of the
last chapter. Every single stock investor should be executing
covered calls at one point or another. But we digress, let's
get into it, shall we
Here's the step-by-step guide we'll follow as we progress
through the chapter
1. Own or Purchase Long Stoc
2. Select Expiration Date or Contract Mont
3. Choose the Call Option Strike Pric
Step 1: Own or Purchase Long Stock
With so many stocks to choose from, it can be daunting to
know where to start. And before we get any further, let's be
clear with the following point. There is no single answer as to
which stocks you should or shouldn't pick to set up a covered
call strategy; it's ultimately a personal decision you have to
make on your own
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NOTE: Throughout this book, we refer to the underlying
security mostly as stock ownership in a company. Most
investors who transition into covered calls do so via
ownership in individual company stock. However, it should be
noted that you can and should sell covered calls on ETFs.
So, please don't misunderstand our use of the word "stock"
to mean that we only suggest initiating covered calls on
individual companies - we don't. We believe you can and
should sell covered calls on any underlying you have an
ownership in, stocks, or ETFs
The purpose of this section is not to tell you which stocks to
trade covered calls on, instead, offer some key decision
4. Monitor & Adjust Position As Neede
Chapter Thre
It seems simple enough right? It is broadly speaking. But
each step has its unique risks that could cause the entire
strategy to fall apart or at that least not perform at the optimal
level it could. So, let's tackle the rst three steps in this
chapter, which will get you the point at which you can place a
new trade. We'll save the last step on monitoring and
adjusting positions for the next chapter
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Factor #1 - Optionable Stocks & Liquidity Filters
By now, it should be evident that you cannot use a covered
call option strategy on a stock that isn't, well, optionable. It'd
be like trying to drive a car without wheels; it's just not going
to happen. Therefore, the easiest and quickest way to lter
the possible universe of stocks and ETFs down is to rst look
at the availability of options. Second, the liquidity of the
options contracts for each underlying
Surprising as it may seem, many companies still do not have
a derivatives market for options contracts. Even if you
wanted to execute a covered call strategy, there might not be
a market for options that exist for that security. Naturally, the
rst scan we can run then is to lter for only the optionable
stocks. Most broker platforms can easily do this for you in a
couple of clicks of the mouse, so let's continue moving
forward
Once you nd all optionable stocks, the next hurdle to jump
over is ltering for a large and liquid options market. Liquid
markets allow you to more easily enter and exit covered call
positions and at better prices. This step is crucial and
requires a little more digging and research, so take your time
and get it right
Liquidity is a uid thing, pun intended. What seems like low
liquidity for one stock might be high for another. For example,
GOOGL and AAPL are higher-priced stocks, which means
you don't need to sell as many covered calls on them to
generate high option premiums. Other lower-priced stocks
like WFC or BAC leave room for you to not only purchase
more shares at a lower price but then require that you sell
more covered calls to capture the same premiums as selling
one or two calls in higher-priced stocks. There's no right or
wrong answer necessarily since it's all relative, so here are
the key points of focus when reviewing the liquidity of the
options market
First, make sure there are a variety of contract months
available. You want to see many months of options contracts
in the option pricing table. Multiple months tell us that there's
a strong demand from investors for buying and selling
options in various periods. If the stock or ETF has weekly
options, that's an even stronger indication that the market
can handle and support a larger group of investors
Second, you want to check the liquidity of the front-month
expiration contracts, which expire in the next 30 days. These
will typically be the most active contracts, and ensuring their
liquidity is vital to a possible covered call options strategy.
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points that might help you decide which stocks are suitable
for your account and investing pro le. We believe there are
three main factors you should take into account when it
comes to choosing your underlying stock or ETF. We'll brie y
touch on each of these areas to give you a clearer picture of
what types of information you should be looking for when
choosing stocks or ETFs
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The two metrics we'll look at speci cally to judge the liquidity
of a market are Volume and Open Interest
Volume shows us the activity of the options market on a
given day, and open interest shows us the depth of the
market for contracts still outstanding. You might think about
these two metrics as measuring the depth and speed of a
market, like that of a raging river - the deeper and more
active the market, the better. Shallow, stale markets (swamplike) should be avoided and offer minimal opportunity. Ideally,
there should be thousands of options contracts in volume for
a given day and tens of thousands of contracts in revolving
open interest across multiple strike prices
For clarity, each strike price doesn't need to have precisely
1,000 contracts traded in volume or exactly 5,000 contracts
of open interest. What we mentioned above are just
guidelines or road markers you might use as you scan for
possible investments. You'll learn to quickly recognize
excellent liquidity by merely looking up and down the options
pricing chain
If these two metrics hold up, the tight or narrow bid/ask
spreads will surely follow. This means better pricing and
easier lls for your covered call. To help train your eyes,
we've pulled together some bad and great liquidity examples
below
Bad Liquidity Example
Notice that both the volume and open interest for the closest
ATM call options, the $25 strike price, in the next month are
lifeless. Just 6 contracts are oating out there somewhere.
Yes, the stock is optionable, but the options are illiquid. If you
think that this pool is deep enough to swim in then you’re
sadly mistaken
Next up is NNN, a fairly large company that is held within
many ETFs and Indexes as well as traditional investors. Here
we’re showing the closest ATM call options which are the $60
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First up is an old favorite of ours that we use often in courses
and webinars. Mainly because the ticker symbol is GOOD,
and yet the liquidity is anything but good. In fact, it’s nearly
non-existent
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strike. Yet, once again, we see the lack of liquidity in the
options contracts
Admittedly, it’s not as bad as GOOD on the previous page,
but it’s certainly not liquid enough either. The contract has
much more open interest but it’s still far below anything we
would touch. Plus, the volume reading of zero suggests at
the end of the trading day, when we grabbed this screenshot,
that the market for options on NNN is extremely quiet
Great Liquidity Example
Enough with the garbage liquidity examples. Let’s review
some amazing liquidity examples. Naturally, the rst one we’ll
review are the call options for SPY, which has the most liquid
SPY, in our opinion, should be your “north star” when it
comes to scanning for liquidity. It sets the bar very high with
more than 55,000+ contracts of open interest and 24,000+
contracts traded today. Not this week or yesterday; today!
And this is only on a single call option strike price in a single
expiration period
Let’s pull up one more example and look at the call options
for GLD, a major gold ETF
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options market of any ETF or stock. Here we’re showing the
closest ATM round strike call option at $310 strike price
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Looking at the $139 call strikes, which is the closest ATM
contract, we see both open interest and today’s volume in the
multiple thousands. This call option isn’t as liquid as SPY but
it’s within our general guidelines. If you are trading a handful
of covered calls, you’ve got more than enough room to get
contracts lled without much of a struggle.
The question now is, do you always need to trade tickers as
liquid as SPY and GLD? Nope. The goal is to distinguish
between bad and great liquidity. So long as you follow the
general guidelines we’ve presented earlier, you should nd it
fairly easy to enter and ll orders
Factor #2 - Fundamental or Technical Analysis Filter
Now, you're a pretty smart person if you're reading this book,
and chances are you've done well enough to have some
money set aside for investing purposes. Most new covered
call traders, therefore, are well-versed stock investors and
already study or should be studying, company nancials and
earnings reports. Therefore, one of the rst ways you can
lter the universe of stocks to purchase for a covered call
strategy is to use fundamental analysis lters. There are
many hundreds of lters you can use, and we don't dare pick
any here that you would focus on since the best indicators
can vary per industry or sector. Instead, we'll list some of the
more popular lters being used for you to explore in your
spare time
•
Price to Earnings (P/E) Rati
•
Price to Cash Rati
•
Debt to Equity Rati
•
Forward P/E rati
•
Price to Free Cash Flo
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Filters for fundamental or technical analysis could have been
the number one item on our list for choosing a stock. Still, we
wanted you to focus on the liquidity of the underlying options
because, without that, it'd be pointless to review the next
steps. All the analysis in the world would be worthless for a
covered call investor if you cannot trade liquid options
contracts on your prized stock pick, right
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•
Earnings Per Share Growt
•
Price to Book Rati
•
Dividend Yiel
•
Cyclically Adjusted P/E (CAPE) Rati
•
Many more..
The second way you could lter for possible securities to
purchase for your new covered call strategy is to use a
combination of technical analysis indicators. Technical
analysis is a method of examining past market data to help
forecast potential future price movements. Using different
tools, indicators, and charts, investors can often generate
signals that leverage current and historical market data to
anticipate a stock's future or projected path
Personally, if we were forced to purchase long underlying
shares, we'd choose companies or ETFs with a long history
of paying a stable, high-yielding dividend trading at a low
CAPE Ratio. An ETF yielding 4-5% per year in dividends
helps to reduce costs basis and smooth returns over time.
Couple this with a simple covered call strategy, and you now
have, not one, but two ways to reduce costs basis and
generate income on an underlying which further increases
your chances of success. Multiple streams of income are
always more stable and attractive in our book
Whatever you choose or however you analyze the
fundamentals of a company, if you plan on owning shares for
the long haul, you'd better have a solid understanding of the
business, it's growth, the industry they are competing in, etc.
Don't invest because you love the founder or CEO. And
please don't invest because of a tweet, post online, or article
you read in the newspaper. Invest for value and expected
returns. Buying stock is buying ownership in the company,
and you should never forget this
This all sounds very sophisticated and cool. Use some secret
indicators that predict stock movement while you're sipping
drinks on a beach somewhere. The truth is that most
technical analysis indicators are terrible predictors of market
direction and stock returns. How can we be so bold as to
make this claim? Well, we had our research team spend an
entire year testing the validity and predictive power of the top
17 most popular technical analysis indicators. We tested and
analyzed more than 1,476 indicator variations over 20 years
to see which worked and which did not
Not surprisingly, only a few indicators and speci c settings
generated reliable signals and excess returns above the
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Often this means that you'll be trading in and out of
underlying stock more often and on shorter timeframes. It
likely won't be day trading but rather what we call "position
trading," in which case you might hold a stock position for a
few weeks or months between entry and exit signals. During
this time, you can sell covered calls to further increase your
probability of success on any long stock positions you enter
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What's the moral of the story for technical analysis? First,
you don't have to use technical analysis to trade covered
calls. Are they required? Nope. Can they help? You bet. And
if you are going to use them, it's essential to use the best
indicators and settings. Anything else could be damaging to
your likelihood of success. Once again, we did the research
for you and published all our ndings in the ground-breaking
publication called The Signals Report, which you can nd on
our website
Factor #3 - Covered Call Yield & Return Filters
If you've checked all the items above and nd a company or
ETF with a liquid options market that you want to own, the
last lter is to run a couple of simulated trades. These allow
you to double-check the covered call yields and returns you
might expect moving forward. Although you might be very
excited to get going by jumping in with both feet, we highly
suggest you do some simulated trading over the next couple
of weeks or months
You want to get a decent idea of what the option premiums
are you'll be receiving if you start selling covered calls. It
might take some monitoring, and you should watch how
option pricing changes during a couple of different expiration
cycles for your target stock. Besides, if you're planning on
investing in stock for the long haul, what's another month or
two of analysis to make sure it's the right move for a covered
call? We think you'll nd that patiently observing for a small
period of time results in more con dent decision making, and
ultimately more pro table investments
What should you look for, or what benchmark should you use
then for covered call yields? As far as targets are concerned,
a great guideline would be to collect around a 1% premium to
stock price yield per month. We use the word "collect" here
speci cally as we're referring to the option premium or option
price at the time you initiate the covered call. For instance, if
a stock is trading for $100 per share, you might have a target
to collect approximately $1.00 of option premium per month,
on average, selling covered calls
The premium you collect may or may not be the nal pro t on
a single position.This is a general guideline, and you can, of
course, go higher or lower than this gure. As a starting point,
you could sell the 30 Delta call options in the one-month
expiration contracts as the basis for your analysis. Recall this
is the setup that the CBOE uses currently that outperformed
the S&P 500, though we know there are better setups we
could possibly use
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market. To put even more context on this, less than 5% of all
the variations we tested had predictive power in a stock's
future direction more signi cant than 50% accuracy. In
English, this means that the vast universe of indicators out
there, for all intents and purposes, are less predictive than
ipping a coin. Of those in the 5% bucket, only a tiny handful
was signi cant enough to use for investing purposes
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Once you add this to the 3-4% dividend yield per year,
provided your stock doesn't get called away, you will be
receiving a nice regular income of around 15-17% in
dividends and cost basis reduction overall each year. Not too
shabby, right? Nope, seems pretty attractive
contracts. A call option 90 days from expiration will lose less
value per day than the same strike call option 30 days from
expiration. The front-month contract is running out of time,
and therefore, the theta decay speeds up as expiration
nears
There you have it, the three primary factors we believe you
should review and analyze when choosing your underlying
stock for a covered call strategy. We meant for this to be a
little subjective on many levels, as it should be. Trading with
covered calls is a long-term investment in stock, and you
should make sure that it ts within your personal goals and
risk tolerance levels before moving forward. In the next
section, we'll help you decide which expiration date or
contract month to target
When it comes to implied volatility, the roles are reversed.
Longer-dated (back-month) options contracts react more to
changes in implied volatility than shorter-dated (front-month)
options contracts. This is because a small change in implied
volatility now, which is extrapolated out over a longer time
period, could have a major impact on the expected stock
price
Step 2: Select Expiration Date or Contract Mont
Now that we've got a stock picked and own shares in the
underlying, we'll start using some live examples to
demonstrate how you might think about choosing the
expiration date in which to sell your covered call. Before we
keep moving, we want to highlight the general impact of theta
decay (time decay) and implied volatility on options pricing
again. Recall that an option's premium or price may react
differently to theta decay and implied volatility in various
expiration periods
A call option 90 days from expiration will witness its price rise
much higher on a relative basis due to increasing implied
volatility than the same strike call option 30 days from
expiration. The front-month contract is less reactionary to
changes in implied volatility, which may or may not have
enough time to play out before the expiration date. Given a
choice, we'd always prefer to start selling covered calls when
implied volatility is high, and option pricing is high as a result
Good so far? Great! Now, let's look at some call options in
different expiration months for SPY. The front-month
contracts expiring in September are approx. 22 days from
expiration
Longer-dated (back-month) options contracts erode at a
slower pace than shorter-dated (front-month) options
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Notice the relative option premiums of the $291-294 OTM
calls on the right side of the pricing table. They range from
$2.23-0.98 per contract
The back-month contracts expiring in October are approx. 50
days from expiration. Notice the relative option premiums of
the $291-294 OTM calls on the right side of the pricing table.
They range from $3.60-2.18, signi cantly higher than the
September contracts. The additional premium is mainly due
Keep in mind at this stage that since we are selling call
options, we want to generate the highest return on the option
contract as possible while also not impeding the upward
mobility of the stock. We achieve this when the option
premium quickly falls in value after order entry or goes to
zero by expiration. Granted, we also don't want this to
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to the additional time and volatility (extrinsic value) given to
the back-month options
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So how far out in time should you sell covered calls? 22 days
or 50 days? Well, it depends. It may seem like both front, and
back-month options contracts have bene ts and drawbacks,
and you'd be right. The answer then is that you need to align
the expiration date or contract month with both your
willingness to monitor and manage the position and the
available premium to be collected. Our Covered Calls
Performance Research Report will also help guide your
decision-making process after reviewing the performance of
various expiration periods
Step 3: Choose the Call Option Strike Pric
Deciding the nal strike price for selling a covered call might
be one of the harder considerations an investor has to make
for this strategy. Sell a call option too close (high delta), and
you collect a high premium but give the stock very little room
to move before capping your pro ts at the lower strike price.
Sell a call option too high above the stock price (low delta),
and you collect a lower premium but give the stock more
room to rally higher before you cap your gains with a higher
strike price. There are risks and rewards to each style or
avor you choose so take your time picking on that’s right for
you and your portfolio
One guiding light might be the CBOE's Buy-Write Index
(BXM), which sells an ATM call option on the S&P 500.
Effectively this is selling a 50 Delta call option every month,
and the results prove the point we outlined above. The
annualized return of this aggressive covered call strategy
was 8.50%, with a standard deviation or portfolio volatility of
10.60%. These metrics are both less than the 30 Delta call
option strategy (BXMD) and the S&P 500 itself. It proves that
selling closer ATM (high delta) call options does help to
reduce volatility in the combined strategy, but at the sacri ce
of overall gains and performance. Naturally, there's a delicate
balance here that you need to nd that works for you
Continuing with our examples, we'll again look at the same
call options in different expiration months for SPY. Only now,
we'll assume that we'd like to sell a covered call near a 30
Delta with a target probability of success around 70%. The
closest strike price to our target 70% success level in the
front-month contracts expiring in September is the $292 call
options with a price of $1.73 per contract
ATM Covered Call Performance (Fig. 2
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happen at the expense of the stock shares crashing, but right
now, we're just referring to the short call option contracts,
independently of the underlying stock
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Figure 2: Value of $1 Invested - CBOE Buy-Write Index Return (BXM)
$30
$25
$20
$15
$10
$5
SPX
BXMD
BXM
$0
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1990
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1994
1996
1998
2000
2002
2004
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2008
2010
2012
2014
2016
2018
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The closest strike price to our target 30 Delta and 70%
probability of success level in the back-month contracts
expiring in October is the $293 call options with a price of
$2.61 per contract
Which one do you pick? Tough question for sure. Ultimately
the decision is either driven by data, from backtesting
research, or a personal decision based on your risk pro le
and need for either growth or security with your positions.
Here's the trade-off you need to consider which might help
steer you in the decision-making process
If you sell the front-month options, you will collect a lower
premium at a strike price that's only $2 above the current
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market price. In exchange for the lower premium and higher
risk of the stock breaching the strike price, the stock only has
22 days until expiration, and time is running short. If you sell
the back-month options, you will collect a higher premium at
a strike price that's $3 above the current market price. In
exchange for the higher premium and further out strike price,
the stock now has more time, 50 days until expiration, to
move against your short call.
Conclusio
If you've followed the rst three steps outlined in this chapter,
you're now ready to enter your rst covered call trade
of cially. With all the pieces together, the process of actually
placing the order in your broker platform should be relatively
straight-forward. You already own the stock (or are
purchasing it) and have selected your target expiration date
and strike price of the call option contract. Now, place the
order and turn the page. If you still need help or have
questions, please reach out to our team at Option Alpha.
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Chapter Four
Position Management
If you've reached this chapter, you should have
your new options strategy executed and working
its magic. In essence, you've made it. You're an
options trader now
Earlier in this book, we reviewed the overall strategy of a
covered call, proved using the CBOE data that they can
outperform the major stock market index, and nally helped
you determine the right expiration months and strike price
ranges to target. And since you're on a new level with your
trading, we'll assume you're also smart enough to know that
it's not always roses and sunshine trading covered calls
NOTE: In the Options Basics chapter, we walked through a
similar framework, but at that time, it was explicitly dealing
with single long call and put options. In this exercise, we'll
approach this only from the standpoint of a covered call
investor
To help build some context for our discussion, let's assume
the following options pricing table exists for the ticker EWW
(iShares MSCI Mexico ETF)
Stocks do move down from time to time - shocking right. So,
what happens now? Now that you've got this covered call
strategy working, how do you manage or adjust the position if
it starts to go wrong
First, don't worry; we wouldn't have carried you this far to
abandon you now. In this chapter, we're going to take a look
at all of the different scenarios that could happen with a fully
executed covered call position and how you should react or
adjust your position if necessary. Remember to always take
your time and work slowly. There's never a need to rush the
process
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With this pricing table in front of us, we’ll also assume the
following covered call strategy is executed
of this section, we'll also suggest ways to hedge or adjust the
trade to reduce risk. Let’s start with the best outcome
1. ETF is trading currently for $51.73 per share
Outcome #1: Stock Rallies Above Strike Pric
2. You purchase 500 shares at $51.73 for a total cost of
$25,865
One of the most common concerns options traders have
when setting up a covered call strategy is what happens
when the stock, EWW, in our example, rallies above the
strike price of the short call option you sold? Does this mean
that your shares will be "called away" or exercised and
assigned immediately to the option buyer? Should you buy
back the short call option to keep the stock position or let
your stock be called away? Well, there are several points we
need to cover to answer these questions
3. Your target for the covered call is the 30 Delta strikes
representing a 70% probability of success
4. You sell the $52.50 strike call options for $0.89 in option
premium per contract
5. You sell ve contracts that cover the 500 shares you just
purchased
6. The call options expire in 22 days from today
7. The cost basis on the shares of the ETF is reduced to
$50.84 because of the premium collected
8. The total premium of $445 is subtracted from the original
total cost to a new, net total cost of $25,420
9. You have reduced your cost basis on the EWW shares by
1.70%
Now that you’ve got your trade setup and working in EWW,
there are ve possible outcomes and corresponding potential
actions you could take. Where appropriate towards the end
With 20 days left, there's still a decent amount of extrinsic
value left in the contracts, and the option buyer would forfeit
that extrinsic value by assigning the option contract in
exchange for shares early. They won't do that because it
would be nancially unwise to do so. However, if you were to
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First, the most important thing to understand is that just
because EWW rallies higher, does not mean you will
automatically lose your long shares. Most assignment of
stock by the call option buyer happens the week of
expiration, and more speci cally, the last few days of
expiration. At that point, the option contract has little to no
extrinsic value left. So, if the stock rallies above your strike
price but you still have 20 days to expiration, there's a high
probability you will not get assigned by the option buyer
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wait right up until expiration and the stock was still trading
higher than your strike price, then you are at greater risk of
your stock getting assigned and called away
Let's assume for whatever reason that your EWW shares are
exercised and assigned to the option buyer, and you no
longer own the underlying stock. Well, remember when
mentioned earlier in the book that this might be one of the
best-case scenarios? Having your stock assigned is not a
bad thing; in fact, it might be the ultimate goal because, after
all, you wanted the stock to rally higher, didn't you? That
said, some people get upset that they didn't participate in the
new higher stock price above the strike price level. And we
understand that concern, but these strategies have capped
upside pro t potential in exchange for a much higher
probability of success. You can't have your cake and eat it
too
The pro t you can receive is limited to the difference between
the $52.50 strike price and the $51.73 stock price when you
purchased the shares, plus the credit received from selling
the out-of-the-money call, $0.89. If EWW rallied well above
your $52.50 strike price, and your stock is assigned, you just
captured all the potential pro t possible in a single expiration
period. Go ahead, pat yourself on the back. The reason you
got paid a premium selling a call option, $445 in total, is
because you forfeited your right to any pro t on the stock
beyond the $52.50, and that's okay
Outcome #2: Stock Rallies, Stays Below Strike Pric
This outcome is the second most favored among covered call
traders. If EWW rallies but the shares remain below your
strike price of $52.50 at the end of the expiration cycle, then
the options contracts expire worthless, and you don't need to
do anything. As the call option seller, you get to keep the
$445 premium you collected from the buyer as pro t, and you
also get to keep your long shares of stock since the stock
never breached the strike price. The stock value increased,
and you kept the entire option premium as pro t, win-win.
Now, go sell another covered call and repeat the process all
over again next month
Outcome #3: Stock Moves Sideway
A highly likely scenario is that EWW trades in a sideways
range around your original entry price. Remember that
markets are both cyclical and relatively random. Maybe up a
couple of days here and there, down some other days,
ultimately moving sideways with no clear direction. If this
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Hitting lots of singles as opposed to swinging for home runs
is an excellent strategy for generating consistent, reliable
income. And, well, higher overall returns with less risk in the
process. Need a refresher? Go back two chapters and reread the performance of covered calls vs. the S&P 500.
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happens, then this outcome is probably the third-best one
you might expect
At expiration, you didn't lose any value on the stock you own,
but you also get to keep the entire $445 option premium as
pro t from the short covered call. Sure, you didn't see the
stock rise in value, yet you got paid for waiting around, selling
the covered call, and reducing your cost basis on the shares
in the process. Now you can re-establish a new set of short
call option contracts in the next expiration month and repeat
the entire process
Outcome #4: Stock Trades Lower, Continues Fallin
Let's be honest, rational adults with each other for a moment.
There's a 50/50 chance that your beloved EWW shares go
down at some point during your covered call expiration cycle.
Yes, this means that not all stocks go up, and it will happen
to you at some point. But since you are selling covered calls,
you're doing yourself a big favor when it comes to cost basis
in this unfavorable scenario
Because you sold a call option for a premium, your new
break-even point, or cost basis, on the stock was lowered to
$50.84 per share. Therefore, the stock could effectively drop
from $51.73 to $50.84, and you would not lose money overall
on the combined covered call strategy. Any drop below
$50.84, and you would lose on the overall strategy due to the
decline in the underlying stock shares. At expiration for this
fourth outcome, the short call option is now far out-of-the-
All that being said, you should continuously re-evaluate the
EWW position and make sure you are still comfortable
owning shares. The cost of owning the shares takes up the
bulk of capital for the position. Therefore, the stock itself is
the most critical factor to monitor
If you decided you want to sell the stock, you need to rst
close and buy back the short call option or wait until your call
option has expired. Exiting the stock position while leaving
the short call option open and working would expose you to a
short naked option position. This translates into potentially
higher margin requirements and additional risk you may not
want
Outcome #5: Stock Has Upcoming Dividen
This scenario is speci c only to those stocks and ETFs that
pay dividends. In our example, we selected EWW speci cally
because it does pay dividends quarterly, in which case we
can walk through the scenario without changing ticker
symbols. Before we go any further, please understand that
dividend payments and early assignments as a result of
dividends will not occur as often as you think it might
You should always be aware of when your stock or ETF pays
monthly or quarterly dividends. Not only because you'd want
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Chapter Fou
money and will expire worthless, freeing you up to reestablish another short, possibly at a closer strike price in the
next month
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When a stock or ETF, like EWW, is about to pay an upcoming
dividend, the risk of early assignment increases dramatically.
The kicker is that the risk of early assignment only impacts
those call option strike prices that are deep-in-the-money.
These would be the call option strikes that are below the
current stock price. These contracts could potentially be at
risk of early assignment because the call option buyer, on the
other side of your trade, might be motivated to exercise their
contract early
it might seem a little complicated at rst, but it's a
fundamental concept
The question naturally then is, what does the put option strike
price have to do with our covered call option? Think back to
the rst chapter on Options Basics and recall that the goal of
the call option buyer on the other side of your contract
originally was to take a risk de ned, bullish position on EWW
stock. Their risk was limited to the premium they paid you of
$445, and in exchange, they get all the upside potential
beyond the $52.50 strike price and their respective breakeven point
The call option buyer would choose to do this in order to
purchase shares from you and collect the upcoming dividend
payment. Seems rational, right? But how can you tell if the
particular strike price of $52.50 that you are holding is at risk
of early assignment of your shares? It's straightforward,
actually.
If they now are interested in assigning the option contract,
they would only do so when they can use the money
collected from the dividend to immediately purchase a long
put option at the same strike price as the original call option.
It sounds complicated, but it's not. The call option buyer is
willing to go through the exercise process to assign shares;
however, only if they can use the money collected from the
dividend to become risk de ned again
To determine if your short call option is at risk of early
assignment, look at the price of the corresponding put option
contract at the same $52.50 strike price. Short call options
are at risk only when the value of the corresponding put
option at the same strike price of $52.50 is valued less than
the dividend payment scheduled. You should re-read that last
sentence again, potentially two or three more times, because
Holding long shares of stock while also purchasing a long put
option for protection is the same synthetic position as a long
call option. It's the same payoff diagram, just constructed with
different components. In this case, all the call option buyer
would do is use the money from the dividend payment to
nance or pay for the purchase of a put option contract for
protection against the stock shares
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Chapter Fou
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to collect this money as the stock owner, but also because
you could be at risk of early assignment. How does it work,
and why should you care about dividends payments and
dates as a covered call investor? Let's discuss
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Let's walk through an example assuming that EWW is now
trading at $55 per share, making your $52.50 strike call
option an ITM position. This week EWW announced it will be
paying a $0.35 dividend per share. On the day before the
stock trades ex-dividend, the corresponding put option at the
$52.50 strike price in the same expiration period as your
short call option is trading for $0.30 per contract. In this
scenario, you would be at risk of early assignment of your
call option contract and here’s why
It should be evident now that not all in-the-money (ITM) call
options are assigned just because they are ITM. This is a
common misconception about the early assignment of a
short call option as a result of dividends. Just because your
option is ITM around the time of dividend payment, doesn't
mean you are at automatic risk of assignment. It is only if
your call option contract is ITM, and the corresponding put
option at the same strike price is valued or priced less than
the dividend payment
The call option buyer could exercise the call option contract,
purchase shares at the $52.50 strike price from you, get paid
the dividend of $0.35 per share, and use $0.30 to
immediately purchase a $52.50 strike put option contract for
protection. Effectively getting them back into the same risk
de ned, bullish position in EWW only now a little richer by
$0.05 per share. Bing, bang, boom
Have a look at your broker platform on the day of ex-dividend
to check if you are at risk of an assignment or not. If you are
at risk, then you either need to close out the call option
contract or roll it over to the next month, discussed next,
where option premiums are higher. Assignment happens on
the day the stock goes ex-dividend so make sure you know
when this is so you can be one step ahead and not caught off
guard
Alternatively, let's assume that the same stock price setup
exists as above, only now the corresponding put option at the
$52.50 strike price is trading for $0.50 per contract. In this
scenario, the call option buyer would not exercise their
contract and assign shares. It would cost them more money
overall to buy shares at $52.50, collect the dividend of $0.35
and then pay $0.50 to purchase the put option protection. It
would be nancially a net loss plus they are better off to keep
the call option contract and forgo assigning you, the call
option seller
It's easy to sit back and watch the pro ts roll in as the stock
you are trading rallies higher during the expiration month.
This happens about 50% of the time and requires no effort on
your part. Go ahead, keep kicking your feet back and sipping
your chilled drink
The other 50% of the time, the stock falls during your
expiration period. When this happens, there are a couple of
ways to adjust and manage the position to reduce risk. Note,
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Covered Call Adjustment & Rollin
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we're not talking about fully turning the position around into a
winner all the time, but instead taking a potentially signi cant
loss and cutting it down into a smaller loss
The rst way to reduce risk is to adjust the covered call strike
price in the same expiration month by moving it closer to
where the stock is trading. You may often hear the phrase
"rolling down," which is just fancy trading jargon that means
closing one strike price and re-opening another, lower strike
price, typically in the same expiration period
Using our primary example for the chapter, let's assume
EWW dropped to $49 per share, below your $50.84 breakeven price. At this point, your short $52.50 call options which
you sold for $0.89 might drop in value to just $0.20 each. You
could then choose to repurchase these $52.50 call options
and close them for a quick $0.69 pro t and immediately resell a closer call option strike price, say the $51 strike price
that is now quoting a price of $0.70 per contract
The net impact by adjusting your call option strike price lower
is that you took in an additional net credit of $0.50 for each
option rolled down. This re ects the premium received from
selling the $51 calls at $0.70 each, less cost to buy back the
$52.50 calls at $0.20 each. Your new overall credit from both
call option sales, the original entry and this new adjustment,
is $1.39 per contract, or $695 in total
The real "magic" when using this type of adjustment
technique is that you are taking advantage of the downward
Yes, at the moment, you're still losing money. But had you
not executed the adjustment, you would be down even more
money as your old break-even price was $50.84. The new
break-even price is $50.34. Pretty cool, right? And you can
keep rolling down your call strikes as needed during the
expiration month multiple times if you want
The second way to adjust covered calls is to roll the existing
call options from the current front-month expiration to the
next, or further out, back-month expiration. In the adjustment
example above for EWW, we rolled call option strike prices
down from one strike to another strike in the same month. In
this second adjustment technique, we are instead rolling the
call option strike out in time to give the stock more time to
recover potentially
You'll often nd that rolling out in time to the next month
accomplishes the same goal of collecting an additional credit
without having to sacri ce your upside potential selling a
closer call option. This works because an option contract with
more time until expiration is more valuable, all else being
equal. So you might nd that the same strike price of $52.50
in the next expiration month pays the same amount of money
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Chapter Fou
move in the market by increasing your overall credit. The
adjustment reduces your cost basis on the EWW shares
even lower and moves your break-even point down to $50.34
from $50.84. With the stock trading at $49, you are within
striking distance of a pro t on any small rally in the shares
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as a closer strike price at $51 in the front-month expiration
we analyzed above
The process of rolling the call option out in time is the same
mechanically as it is for rolling the call option down. You
simultaneously buy back and close the $52.50 call options
that expire in 22 days while re-selling new short call options
at the same $52.50 strike price in the next contract month
that expires in 50 days, for example. The trade-off is that by
rolling a call option out to a further expiration month, you
might have to wait longer for your pro t on the premium to be
realized. On the other hand, because you didn't move the
strike price of the call option lower, you are leaving more
room for the stock to rally
Conclusio
Whichever method you favor as you start monitoring and
adjusting covered call positions, recognize that being
proactive is crucial. When the stock drops and you roll your
short call option either closer and down or out to the next
month, it allows you to increase your overall credit in the
position and ultimately reduces risk. Is one technique more
favorable than the other? Not really. There's no perfect
answer, and each situation is going to be a little different. As
always, you have the option, pun intended, as to which
adjustment technique seems most appropriate for you
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Chapter Five
Synthetic Strategies
What if we told you that as much as you might
have fallen in love with covered calls during our
amazing, self-admittedly, blueprint in the last
couple of chapters, there were better
alternatives
Alternatives that required less money to get started and
performed practically the same, and in some cases, much
better long-term. Alternatives that gave you the ability to
diversify across more stocks and ETFs and leverage the full
power of options. Starting to salivate yet? Well, it's true, and
we'll show you how.
In this nal bonus chapter, we'll explore the two main
alternatives to trading covered calls without the requirement
of purchasing the underlying stock. Yes, you don't have to
outlay thousands of dollars to buy stock to trade a covered
call option strategy. Together let's examine these alternatives
we’ll refer to as covered call “synthetics strategies.
Synthetic Strategy #1: LEAPS Options
The rst synthetic covered call replaces long shares of stock
with the purchase of a single deep ITM call option in a fardated back-month expiration. This type of call option contract
is commonly referred to as Long-Term Equity Appreciation
Security (LEAPS). It acts as a synthetic in place of
Why do this? Well, there's no debating that the capital
requirements for stock ownership can be incredibly high. For
example, the Russell 2000 Index EFT (IWM), is currently
trading at approximately $172 per share at the time of this
writing. To purchase 100 shares of IWM, you would need to
invest at least $17,200, a gure that is 70% higher than the
average brokerage account opening balance in the US. All
that money so you can sell one covered call against the stock
while still carrying the full downside risk of the market moving
lower? No thank you. It seems like a lot of risk, in our opinion,
to gamble on a single ticker that may or may not work out?
We're sure you can see our hesitation with stock ownership
If we agree then that stock ownership may not be the most
cost-effective way to build a covered call strategy, what else
could we do to replicate the 100 shares of stock? We could
use an option contract of course! Remember that every one
option contract controls 100 shares of stock. Speci cally, we
could purchase a call option with a high Delta value, which
would replicate similar performance of the underlying stock
without having to buy shares outright. This is where LEAPS
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Chapter Five
purchasing underlying stock or ETF shares. You may also
hear people call this strategy a "Poor Man's Covered Call" or
"Skinny Covered Call" as well as many other names, but the
concept is the same. Instead of purchasing 100 shares of
stock, purchase a single (one) deep ITM call option, that
controls 100 shares, and replicate a stock position for less
money
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are used by sophisticated options traders to create a covered
call synthetic
As mentioned, LEAPS are long-term or back-month
expiration contracts. How far out in time exactly? Well, that's
up to you to decide. Generally, any expiration more than six
months out from today's date is a reasonable basis for
starting to analyze a synthetic position. If it's currently
January, then you might look to purchase call options in July
or further out in November if you wanted. The further out you
are buying the call option LEAPS, the more expensive the
options contract or premium will be, but the more time you
have to see the stock move favorably for you
Once you identify the expiration month you are comfortable
trading, you'll look for a deep ITM call option strike price to
purchase. Recall that any call option that is deep ITM will
have a strike price that is lower than the current stock price.
The deeper ITM the call option strike price, the lower the
strike price from the current stock price, and the more the
option contract price will behave and trade as the underlying
shares would
roughly 50 shares of stock. Call options with a Delta of .70
will behave as if you owned 70 shares of the underlying
stock
Ironically, because we know where your mind is already
going, Deltas of 1.0 will not exist until you get much closer to
expiration due to the extrinsic value of LEAPS. Therefore, we
want to potentially target a Deltas around .80 to .90
whenever possible. This will give you the ability to replicate
80-90% of the stock move with a fraction of the cost
compared to purchasing the shares outright. Amazing right
Sticking with the IWM example from earlier, let's look at a
LEAPS setup in an expiration seven months out from now, at
the time of this publication. The options pricing table for IWM
is shown on the following page for the call options which
expire in March of next year. Notice how different the option
prices are for contracts this far out in time to what we've seen
earlier in this book
Thankfully, we can use the option greek Delta to help us
estimate how reactive a particular call option strike price will
be to a $1 move in the underlying stock. A call option with a
Delta of .50 will behave as if you owned 50 shares of the
underlying stock. Your single call option still controls 100
shares of stock at expiration, but the day to day price
movement of the option contract moves as if you owned
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Chapter Five
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option of just $2,092, which controls the same 100 shares.
That's an 87% discount on the cost of purchasing the shares.
As far as capital ef ciency is concerned, need we say more
Plus, there's another added bene t embedded here that we
haven't even discussed; black swan or crash risk. What if
IWM crashes? What if the stock goes down 20% this week
and trades at $137 for the next seven months? Does stock or
a long call option give you more protection
Your option contract has de ned and limited risk, whereas
the stock shares carry all of the downside risks of a market
crash. Trading the call option contract during this 20% drop
would only leave you exposed to a $2,092 loss, or the value
of the option contract, and nothing more. Holding long shares
of stock during a 20% drop would yield a loss of $3,440,
assuming IWM doesn't keep falling. Do you now understand
why trading and investing in the underlying stock is so
inef cient for investors? It's a poor vehicle for controlling and
managing risk
The $155 strike call options, which are well below the current
share price and considered deep ITM, are at an .80 Delta
and are trading for $20.92. In real dollar terms, each call
option contract would cost $2,092
Now, let's pause here before we go any further and look at
the trade-off between buying the stock outright and buying
this deep ITM call option. The cost of 100 shares of IWM
would be $17,200 vs. the cost to purchase a deep ITM call
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Chapter Five
With the deep ITM call option at the $155 strike price now
acting as our synthetic stock position, then the only
remaining step to complete our covered call strategy is to sell
the front-month OTM call options above where IWM is
trading. Using the pricing table for the expiration 22 days
from today, we might look to sell the $176 strike for $1.38 per
contract. This additional premium reduces the cost basis on
the price of the deep ITM call option we purchased from
$20.92 to $19.54 overall. A 6.59% reduction in cost
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Freeing up the additional capital with this one synthetic gives
you much more exibility to diversify your portfolio with other
covered call positions or hold cash in reserve. It always
fascinates us that more investors don't think about or use
options in this manner. The math and numbers certainly don't
lie. But that's why we're writing this book after all! To help
guide and education you on the choices available
Now, are you ready for an even better strategy than the one
presented above? Oh yes, I've been saving one of the best
for last. Enter the pure option seller
Synthetic Strategy #2: Short, Naked Put Option
The nal and absolute best synthetic alternative to a covered
call strategy, is to sell short put option contracts. Just
mentioning the idea of trading short, naked options strikes
fear into many traders as they are inherently associate it with
being high risk and foolish. On the contrary, we believe, and
the data supports, that stock ownership is high risk and
foolish
There you have it, a synthetic covered call position using
LEAPS options with a fraction of the money invested and
signi cantly lower risk. And when expiration comes in 22
days, just re-sell another OTM call option in the next frontmonth contracts while holding the same deep ITM call option
in the further out expiration month. Repeat these mechanics
every month moving forward to maintain the synthetic
position
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Whatever prior connotations or beliefs you held about trading
naked, unde ned risk or uncovered strategies, leave them at
the door for a couple of minutes. We need you, and your
portfolio needs you to keep an open mind about this as we
walk through the setup. Once again, the numbers don't lie on
which strategy ultimately generates the best return metrics,
and carries the least risk
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strike price of the short call option. At that point, the stock
gains are offset on a one to one ratio by the short call option
you sold. This is the trade-off for executing a covered call
strategy, limited upside potential beyond your strike price in
exchange for a higher probability of success overall by
collecting the option premium and reducing your cost basis
on the stock position
To create a viable synthetic position that mimics that of the
covered call strategy, we ideally need to nd an options
strategy that generates the same payoff line shown to the
left. If another strategy generates the same payoff line, then
we can use it as a reliable synthetic, assuming it has a better
risk and reward pro le
Profit
Long Stock
As it turns out, a short, naked put option creates precisely the
same payoff diagram as a traditional covered call. Upward
sloping to the right, then levels off at some value
representing the same de ned pro t or limited upside
characteristics of a covered call strategy. Depending on the
strike price of your short put option contract, the payoff
diagram would be nearly identical to that of a covered call.
Crazy cool
Los
Covered Call
Recall from previous chapters that a covered call strategy
purchases long stock and then sells an OTM call option
above the market price. The blending of the two components
creates the red payoff line shown; an upward sloping payoff
until the strike price of the short call option and then a at
payoff line at any stock price above that level
Short line
Call
It makes rational sense why the red covered call payoff
Low Stock
Highanywhere
Stock Price above the
atlines or levels
out Pric
at stock prices
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Before we reveal the performance of selling short puts to
trading covered calls, let's discuss how and why this acts as
a synthetic alternative. To understand any synthetic strategy,
you need to understand the payoff diagram of the core, or
traditional, covered call options strategy shown again below.
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Profit
Short Put
Los
With this new synthetic starting to take shape, let's look at an
example using the same IWM position we used earlier. To
collect as much premium as possible and mirror the payoff
diagram of the covered call, let's sell the at-the-money (ATM),
Low Stock Pric
High Stock Price
or near ATM, short put options. The $172 strike price is
currently ATM, is quoted at $1.75 per contract, and expires
22 days from today
To complete the synthetic trade, all you would do is sell this
single (one) put option contract and nothing else. Don't
purchase the underlying stock, don't buy deep ITM call
options. Just become the option seller of the $172 strike put
contract. That’s it
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"But Kirk, how can we sell something we don't even own
yet?" Great question, and it brings up some critical points.
First, you have to change gears mentally here a little and
now think about the impact of this short put option contract
from both the buyer and seller perspective. Fire up the brain
cells from the Options Basics chapter about the rights and
obligations of options contracts as opposed to the traditional
stock investor's mindset of buying and selling shares
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A put option buyer purchases the right, but not the obligation,
to sell stock at the $172 strike price before or at expiration.
The put option buyer pays a premium, $1.75 in this example,
for this right to choose. If you are now the put option seller in
this example, you collect the $1.75 premium and have an
obligation to purchase stock from the option buyer at the
$172 strike price if you are assigned on the contract. Easy so
far and should make logical sense
Next up is the slightly confusing part, or at least until you
read the next couple pages. Since this is an uncovered or
naked position, it means you are not required to own the
stock when you enter the trade. "Hold up Kirk, so what
happens if I'm assigned and need to buy the shares from the
put option buyer?
If you were assigned, you would purchase the shares from
the put option buyer at the strike price of $172 per share. If
you didn't want to hold the shares or continue to own the
stock, you could immediately sell the shares back in the open
market at whatever price the stock is trading at currently, say
$171 per share. You have a net loss of $1 on the stock
shares since you had to buy shares at $172 when they are
only worth $171. But you forget something important. When
you account for the option premium you collected of $1.75
initially on the sale of the put option contract, your net pro t is
$0.75 per contract, even after the assignment. Do you see
what happened? You made money even when the stock
At this point, it might seem like selling put options is too good
to be true? You collect a nice option premium up front from
the option buyer, and you don't need to own the stock.
Effectively no money out of your pocket to initiate the
position; in fact, you're getting paid to initiate the trade, so
what's the catch? What could go wrong? Let's discuss this
Understand rst that dummies do not run brokers and the
options exchanges. You wouldn't lend money to someone
you knew had no means to repay the loan, would you? The
same thing generally happens in the options market. The
brokers and exchanges fully understand the risk associated
with any position or options contract. They wouldn't let you
sell the single put option contract without making sure that
you have enough capital to cover the risk should the position
go wrong
When someone decides to sell a naked, unde ned risk put
option contract, the brokers have to determine an effective
way of mitigating the risk to approve the trade while also not
requiring you to purchase the stock. So how do they do this?
They calculate what is called a Margin Requirement
You should think of Margin Requirements as really just a
fancy way of saying that you need to have "reserves" that are
set aside in your account to cover potential losses on your
short put option position. They don't take the money out of
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traded lower because you collected the option premium as
an option seller
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your account; instead, they earmark a speci c dollar value to
the trade and reduce the remaining funds available for new
trades. The amount they will hold in margin depends on the
broker and your account type, but let's assume for simplicity
it is roughly 20% of the value of the underlying shares plus
the option premium collected
Using our IWM example, if the stock is trading at $172 per
share and you were to sell the $172 put option for $1.75 per
contract, the margin that would be required to execute this
trade would be $3,615. The stock price of $172 X 20% +
$1.75 option premium. Again, this money is not taken out of
your account but rather reduces your available funds for
trading to ensure that you have enough money to cover the
risk of this position until it's closed or it expires
If your brokerage account had a starting balance of $10,000,
your broker would earmark $3,615 for this short put option,
which leaves you with $6,385 in available funds for other
trading or investing activities
NOTE: The gure referenced above is just the initial margin
that is required to enter the position. The on-going margin
requirements needed to cover the risk goes up and down
depending on the stock price, implied volatility, option pricing,
etc. For this reason, we highly suggest you consider keeping
short option contract trading, like short put options, to a
minimum in your account and keep their position sizes small
and manageable. As always, too much leverage can and will
blow up your account if used incorrectly
At this point, we've talked at length about the capital bene ts
of selling short put options. And while all of these ef ciency
points from a capital usage standpoint have merit, the real
question is, how does the short put option strategy compare
to the S&P 500? If a short put option performs worse than
directly buying and holding the market index, there's no point
in trading it
Remember the research the CBOE did on the from earlier
chapters? Well, they also tested the performance of trading
just a single short naked put option, referred to as the “PutWrite Index” (PUT), and it generated nearly the same
annualized return with dramatically less risk and volatility in
the portfolio
If that wasn't enough, the put selling strategy also saw higher
Sharpe, Sortino, and Alpha metrics than the S&P 500 and the
Buy-Write Indexes that track covered call strategies. In Fig. 3
you’ll notice that the trajectory of the PUT strategy was both
more stable and continued to outperform the market in most
periods. Since the goal of the PUT strategy is market-like
performance with less volatility, we would expect the strategy
to underperform slightly in bullish markets but outperform
dramatically in bearish markets. This is exactly what
happened and should continue to happen in the future. Plus,
the more ef cient use of capital for a short put option frees
you up to diversify into a wider basket of underlying ticker
symbols
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ATM Short Put Performance (Fig. 3
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Figure 3: Value of $1 Invested - CBOE Put-Write Index Return (PUT)
$30
$25
$20
$15
$10
$5
SPX
BXMD
BXM
PUT
$0
1986
1988
1990
1992
1994
1996
1998
2000
Selling short put options generated an annualized return of
9.54% per year with a standard deviation, or portfolio
volatility, of just 9.90% vs. 14.90% for the S&P 500. The
maximum drawdown was also much lower at -35.50% vs.
-50.90%, respectively. That's a 33% reduction in portfolio
volatility and 15% more money during a market crash
scenario
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Chapter Five
2002
2004
2006
2008
2010
2012
2014
2016
2018
No matter how you slice and dice it, option selling was a
superior strategy when analyzing all facets of an investment
strategy. Short put options witnessed higher returns,
dramatically lower risk and portfolio, with a fraction of the
capital exposure of long stock. Why was this the case
though
First, it might seem on the outside that the synthetic covered
call via the LEAPS offered a cheaper position cost-wise than
Option Alpha © 2019. All Rights Reserved.
61 of 65
the short put option. And while that could be the case in
some contract months, the additional transaction costs and
structure of the LEAPS alternative was a drag on
performance
The LEAPS alternative required more transactions, at least
one to purchase the deep ITM call and another to sell the
OTM call in the front-month expiration, while the short put
option only requires one transaction. More transactions mean
more commissions paid to the broker, which drags down
performance. Additionally, since LEAPS are a combination of
options buying and options selling, the net effect of theta or
time decay on the position was slowed, leading to potentially
longer holding periods
selling, most investors associate them with having insanely
high risk and high volatility in their accounts because of what
they have read online or heard on the news. But when you
look at the data, particularly from a third-party source like the
CBOE, the assumption that put option selling is risky is just
not supported. If anything, it should be viewed as one of the
leading candidates for covered call synthetic strategies
Second, selling option premium has been proven, both by
our research as well as many others, to offer a reliable and
statistical edge over option buying strategies due to implied
volatility’s over-expectation of option pricing. When options
are priced, the implied volatility that market participants
expect in the stock’s future movement is overstated in both
directions long-term. People assume that stocks will move
higher or lower than they actually do. This creates a
mispricing in option premiums, similar to that of insurance
contracts, which bene ts those who are net option sellers
Conclusio
It has often been said that "People don't know what they
don't know." In the case of naked, unde ned risk option
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62 of 65
Final Thoughts…
Congratulations on nishing this book
It's quite an accomplishment and one that many investors did not reach. I'd even
wager to say that just 10% or less of the people who started reading this book
made it to the end where you are now. You should be very proud of yourself
It's my sincere hope that this book was both an enlightening read as well as a
con dence boost in believing that you can, and are now potentially even
obligated based on the data, be able to beat the market performance with less
risk. It's not some mythical unicorn, but it does take a healthy dose of discipline
and consistency
Options trading presents one of the most exceptional nancial opportunities for
investors like you and me. I encourage you to use what you have learned in this
book as the foundation from which to keep pushing forward and exploring new
options strategies and new ways of generating income
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Until next time, Happy Trading!
Author
Kirk Du Plessi
Kirk is the founder and head trader at Option Alpha, which
offers an all-in-one platform for retail investors and traders.
Option Alpha is an industry leader in the options trading
space with rst class education, groundbreaking research,
integrated backtesting, as well as the rst end-to-end
automation technology for options trading strategies
Option Alpha and Kirk have been featured in dozens of publications
including Barron's, Smart Money, Forbes, Nasdaq, and MarketWatch. The
company was named to the #215 spot on the Inc. 500 in 2018 and the #723
spot on the Inc. 5000 in 2019
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Kirk is a former Mergers and Acquisitions Investment Banking Analyst for
Deutsche Bank in New York, REIT Analyst for BB&T Capital Markets in
Washington D.C., and options strategy consultant for multiple funds, family
of ces, and nancial advisors. He holds a Bachelor’s degree in Finance from
the University of Virginia and lives in Pennsylvania with his wife and three
children.
Appendix & References
CBOE Option Strategy Indexes: http://www.cboe.com/products/strategy-benchmark-indexes
Options Basics Guide: https://www.optionseducation.org/strategies/all-strategies/covered-call-buy-write?prt=mx
TD Ameritrade Margin Handbook: https://www.tdameritrade.com/retail-en_us/resources/pdf/AMTD086.pdf
Pricing Table & Quote Screenshots: robinhood.com
Covered Calls Performance Research Report: https://optionalpha.com/covered-calls
Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options (ODD).
Copies of the ODD are available from your broker or from The Options Clearing Corporation, 125 S. Franklin Street, Suite 1200, Chicago, IL 60606. The information ins this book is provided
solely for general education and information purposes and therefore should not be considered complete, precise, or current. Many of the matters discussed are subject to detailed rules,
regulations, and statutory provisions which should be referred to for additional detail and are subject to changes that may not be re ected in the book information. No statement within the
book should be construed as a recommendation to buy or sell a security or to provide investment advice. Past performance is not a guarantee of future returns
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The Cboe S&P 500 BuyWrite Index (BXMSM), Cboe S&P 500 2% OTM BuyWrite Index (BXYSM), Cboe S&P 500 95-110 Collar Index (CLLSM) and Cboe S&P 500 PutWrite Index
(PUTSM) and other Cboe benchmark indexes (the “Indexes”) are designed to represent proposed hypothetical buy-write strategies. Like many passive benchmarks, the Indexes do not take
into account signi cant factors such as transaction costs and taxes. Transaction costs and taxes for a buy-write strategy could be signi cantly higher than transaction costs for a passive
strategy of buying-and-holding stocks. Investors attempting to replicate the Indexes should discuss with their brokers possible timing and liquidity issues. Past performance does not
guarantee future results. These materials contain comparisons, assertions, and conclusions regarding the performance of indexes based on backtesting, i.e., calculations of how the
indexes might have performed in the past if they had existed. Backtested performance information is purely hypothetical and is provided in this document solely for informational purposes.
Back-tested performance does not represent actual performance and should not be interpreted as an indication of actual performance. The methodology of the Indexes is owned by Cboe
Exchange, Inc. Supporting documentation for statistics or other technical data is available by calling 1-888-OPTIONS, sending an e-mail to help@Cboe.com, or by visiting www.Cboe.com.
Cboe®, Cboe Volatility Index® Execute Success® and VIX® are registered trademarks and BXM, BXR, BXY, CLL, PUT, BXMD, CMBO, BFLY, CNDR, CLLZ and PPUT are service marks of
Cboe Exchange, Inc. Standard & Poor's®, S&P®, S&P 100®, S&P 500®, Standard & Poor's 500®, SPDR®, Standard & Poor's Depositary Receipts®, Standard & Poor's 500, 500,
Standard & Poor's 100, 100, Standard & Poor's SmallCap 600, S&P SmallCap 600, S&P 500 Dividend Index, Standard & Poor's Super Composite 1500, S&P Super Composite 1500,
Standard & Poor's 1500 and S&P 1500 are trade names or trademarks of Standard & Poor's Financial Services, LLC. Any products that have the S&P Index or Indexes as their underlying
interest are not sponsored, endorsed, sold or promoted by S&P OPCO LLC ("Standard & Poor's") or Cboe and neither Standard & Poor's nor Cboe make any representations or
recommendations concerning the advisability of investing in products that have S&P indexes as their underlying interests.