If you’re a trader who likes to trade options, there are several profitable trading strategies that you can employ.
Call and put options were originally developed to hedge your bets and ensure that even those with lower amounts of capital could easily trade on the price action of securities.
However, more complex and unique strategies have been developed with time, and covered calls are one of these strategies.
In this post, you will find out what covered calls are, how you can use a covered call calculator, and some of the best covered call calculators available in the market.
What is a Covered Call?
To completely understand what a covered call is, you need to understand what a call option is. If buying a call option confers the buyer the right, but not the obligation, to buy the underlying security at the predetermined strike price. This can be used in two ways, and they have been discussed below with the help of an example.
Call Option Examples
Suppose the shares of a particular company ABS cost $500. You expect this price to increase over the next week and touch $600. The ideal way to act on this belief would be to buy the stock, wait for a week, and sell it at $600.
However, several potential issues could arise here. For example, maybe you do not have $500 to risk on a single trade. What happens if the stock does not rise in a week? Another major issue is that you will be risking the entire $500, and if the stock instead plummets to $250, you will have lost $250.
In such situations, call options can be used. Say you buy a call option on ABS with a strike price of $500 expiring in a week. This means that after a week, you will have the option to buy the share for $500 if you want.
To buy this call option, you will have to pay a premium, say $8. Now, the only capital that you are risking is $8. If the share does not touch your desired target price or falls, you can choose not to exercise the option.
Your maximum downside is protected, and your maximum loss is capped at $8 only. While this will reduce your profits to $92 instead of $100 if the price touches $600 a share, traders still prefer it because of the capped downside and no risk.
How do Covered Calls Work?
While the buyer of a call option expects the share price to go up so that they can exercise the option and make a profit, the other party, who is called the seller or writer, expects the price to fall or stay where it is. Covered calls are a trading strategy that traders can use if they expect the price of a security to stay where it is for the foreseeable future.
In a covered call, the owner of a share writes a call option for the share. The idea is that the writer makes money through the options premium. The ownership of the share serves as the cover because if things don’t go as the writer wants them to, they can give their share to the buyer of the call option instead of buying a share at the current market price.
If a writer sells a call option with a strike price of $500 at a premium of $8, they will expect the price to remain between the $495-505 region. In this range, the buyer would not exercise their option, and the seller would have a profit of $8.
If the trader buys a stock and simultaneously sells a call position against the stock, this is called a “buy-write” transaction.
Who are Covered Calls Suitable For?
Covered calls are only suitable for investors who expect the stock price to remain where it is.
If you’re bullish on the stock, selling a call option would be a bad idea because you would limit your gains to just $8 (the premium on the option’s sale). In this case, it would be a better idea for you to hold on to the stock itself and sell it at a profit. On the other hand, if you are bearish on the stock and expect prices to fall soon, it might be smarter for you to sell or even short the stock.
A covered call would not work in this situation because while you will definitely make money through the unexercised call option’s premium, a fall in the share price would cause losses on your long position and would inevitably result in a net loss.
This type of strategy is usually preferred by long-term investors who believe that the stock will only move with a set range for the near future. Therefore, they opt for using covered calls to generate some quick income before the stock begins to rally.
What is a Covered Call Calculator?
Calculating the maximum risk and return on a covered call might not always be easy, especially if you plan to trade them regularly. This is because there are various factors involved that directly affect the final profit or loss and therefore have to be taken into account while calculating the final figures.
How Does a Covered Call Calculator Work?
A covered call calculator requires you to enter in certain parameters that it will need to calculate your risk, reward, and probability of success.
These parameters include:
- The symbol or the ticker of the instrument that you are trading. For example, if you are long on the Apple stock, then the ticker is $AAPL. This information is then used to get the live price of the instrument for the calculations.
- Your purchase price, if it is not the same as the live price. For example, if you had bought the stock a while ago and only now wish to trade in a covered call, this parameter can be used to consider your actual buying price.
- The number of shares you own. Usually, you will need to own at least 100 shares to write an option, as most options trade in multiples of 100.
- The option you are planning to write. Most covered call calculators will provide you with a matrix that you can choose from, depending on the day of the expiry and the exercise price that you opt to write.
Once you have entered all this information, the covered call calculator returns the maximum risk, maximum return, and the probability of profit on your covered call.
This is calculated as follows:
- Your maximum return is the option premium + any profit you may have if the option is exercised. For example, say you bought 100 shares for $3 each and then wrote a call option with a strike price of $3.10 with a premium of $0.05. Therefore, you make a profit of $5 from the options premium right when writing the option. If the price then exceeded $3.10, the call option would be exercised, and you would have to sell the shares to the buyer at $3.10. Your additional profit here would be $0.10 a share, or $10. Therefore, your total maximum reward would be $15.
- Your maximum risk is what you will lose if the underlying security goes to 0. In the above example, if the security goes to 0, you will lose $300 on your long position. However, you have already made $5 by selling the option. Therefore, your total maximum loss is $295. Since securities do not usually go to 0, this is an extreme case scenario. Most covered call calculators allow you to predefine a lower limit to set your stop loss on the long position. This is then used to determine the maximum risk.
- The probability of profit is derived using the 30-day implied volatility. Generally, traders only choose to write a call option if the probability of success is greater than a predefined number.
The Best Covered Call Calculator
There are several covered call calculators that you could use for calculating the total return, risk, and probability of success on your trades; however, some are better than the others and more preferred by traders. One of the best covered call calculators is the one by Options Profit Calculator.
This offers a simple interface that you can use and understand easily and allows you to compare multiple covered call options simultaneously.
Another highly preferred covered call calculator is the one by Options Education. In addition to having a provision for commissions and margin interest rates, it also allows you to choose between American and European options because the calculation shifts accordingly.
This is more suitable for experienced investors who might want more options and customizations than beginners.
Covered Call Calculator Excel
In addition to using an online covered call calculator, you could also use an Excel calculator instead. This can be done in one of two ways: either you would build your own calculator from scratch or use a template available online.
One of the best covered call calculators excel templates can be found at MarketsXLS. It offers all the same features as a traditionally covered call calculator. It also has a graphical representation of your potential profit and loss so that you can easily view the downside of your trades.
A covered call strategy is beneficial in times of low volatility on the market because it will provide you with the opportunity to generate an income source through options premiums easily.
While the basic concept of a covered call is quite straightforward, the calculations involved are quite complex, and therefore it is best to use a covered call calculator to avoid mistakes. Several covered call calculators are available online, though you could also choose to create your own on Excel.
Nishit is an accounting and finance student at the University of Warwick who has written for a range of blogs and websites including Fortune 500 companies.
He has a passion for the financial markets and has been a keen investor since he was 15.