Out-of-money covered calls explained! A simple options strategy to generate dividend-like income.

If you know all about selling out of money covered calls, stop reading further.

If you don’t, I’ll explain this in the simplest terms, assuming you know nothing about options trading. Let's start with the basics.

What is an option

An option is a financial instrument which grants the buyer the right - but not the obligation - to buy (call option) or sell (put option) an underlying stock at a predetermined price before or at the expiration date. The standard size of an options contract is typically 100 shares, i.e. each option contract represents the right to buy or sell 100 shares of the underlying asset.

What are Call and Put options?

Call options provide the right to buy 100 stocks at a specified price (strike price).

Put options grant the right to sell 100 stocks at a predetermined price.

A covered option is basically when you own the underlying stock, which reduces risk in case your option is exercised.

Wait, then what is Selling Call options?

Selling a call involves offering someone else the right to buy 100 stocks from you at a specified price for a certain premium. And you do that with the expectation that the asset's price won't reach that level, allowing you to keep the premium. Since they now have the right to buy the 100 stocks from you at the specified price, you end up with a potential obligation to fulfill it because you took the premium and “signed” the contract.

But I want to keep my stocks!! Yes - me too. Just select a strike price that way out of money.

Which is why you select a strike price that’s way out-of-money, i.e. its? highly unlikely to hit that week. For instance, for NFLX stock that’s trading at 560 right now, one can select $620 (11% higher) as strike price expiring on 2/9. The stock hitting 620 is ~2% chance. Of course, its non-zero, so there’s always that risk. For a stock like that you can pocket 50-100 premium each week keeping your probability as low as 5% (two standard deviations out).

Deconstructing?the whole concept.

So selling out of money covered calls = selling a call option + which is covered (you own 100 units of the underlying stock) + at a strike price so high that is less than 3-5% it will get there (out of money).?

Example

Consider Meta which closed at $475 on Friday, 2/2, with a record gain in market cap on a day. Meta also announced a 50c dividend per share, i.e. $50 per quarter if you have 100 stocks.?

If I look at Meta’s option chain (see screenshot), someone is willing to give me $45 today (option premium) in order to get the right to buy the stocks from me at $530 a pop (option strike price).?

Their right expires this week, 2/9. So if the stock price is under $530 by the end of the week, I pocket the $45 premium. Because at that point, they are better off buying directly on the market than buying from me.

The likelihood of Meta hitting $530 (12% w/w increase) is < 3.5%, i.e. a price of 530 is more than 2 standard deviations out based on Meta’s historical prices/volatility.?

And one can choose how safe you want to play; you can be safer and choose a higher strike price for a lower premium (e.g. $540/$550 gives you $31/$23 premiums). I am using Robinhood’s probability of profit here - but goes without saying, there’s some level of risk there.

Thus, by selling an out of money call option one can make $45 this week alone.?

Always learning and curious to hear your investment ideas!

A few other things to note

1. I avoid doing any transactions on my employer's stocks. In fact, for my employers I've never explored options and am rarely do stock transactions but within the trading window.
2. I settle or close the option Friday mornings, i.e. pay $1 to buy back the option or roll it (concept for next time).?
3. If there’s risk of assignment (i.e. buyer exercising their option) on Friday or the option is in the red, I just simply buy back my call option (which is what I sold). I’ll make it back the the next week.
4. I avoid earnings week or choose more conservative views sometimes to not get assigned.?

Disclaimer

This is not financial advice and neither is it foolproof. There have been instances where the stock reached the strike price and I took a loss but bought the option back for higher than the premium. So there’s always a risk in the stock market and your financial decisions are solely your own responsibility.?