covered calls are a simple option strategy to manage but there is one management mistake that will guarantee a loss on your covered call position and I will explain that mistake in this video I will also outline a strategy that you can use to recover your money more quickly on a losing covered call position as opposed to Simply holding the covered call by itself covered calls are a very straightforward position consisting of purchasing 100 shares of stock and shorting one call option against those 100 shares if the stock price is below your short call strag price
at expiration then that call option will expire worthless and you will keep 100% of the premium that you collected for it when initially selling it so in this example if we buy 100 shares of stock at $100 per share and we short the 120 call for $300 in premium and the stock price is below that $120 price level at the time of expiration then that 120 call will expire with a value of $0 and that means the profit on that short call Position will be $300 if the stock price went to $115 then we would
have a $15 profit per share times 100 shares for a stock profit of $1,500 this would bring our total covered call profit to $1,800 combining that $1,500 profit from the shares and the $300 profit from the short call position but if the stock price is above your your short call strike price at the time of expiration then you either have to allow the call to expire in the money and sell your shares at the strike price or you have to buy back the short call most likely for a loss if you want to keep holding
your shares and you don't want to sell them so for example if we buy 100 shares of stock at $100 per share and we short the 110 call for $600 in premium and then the stock price goes to 120 well we would have a $2,000 profit on our stock position but that 10 call will be worth $1,000 in premium at expiration since the call would have $10 of intrinsic value so the stock price is $10 above that strike price means the Call's price is $10 and in premium terms that means the Call's value is $11,000
so that would mean that our total profit on the covered call would be $1,600 if we allow the short call to expire in the money then we would effectively sell our shares for $110 per share and our p&l on the covered call position would be $1600 so a $10 gain on the shares times 100 shares is $11,000 plus the $600 in premium that we collected for selling the call brings our p&l to a positive 1,600 the second option if we want to keep the shares is to buy back the short call for a loss but
the difference is since the stock increased by $20 and our profit was $1,600 that basically means our effective share purchase price is $14 since if we buy back that short call for a $400 loss and we spread that loss across 100 shares we effectively increase our purchase price by $4 per share and what that means is if the share price goes back to $104 we will have a $400 profit on our stock position and um that would offset the loss that we took on that short call position so basically what I'm trying to say is
if you have a covered call position and it becomes in the money and you buy back that short call for a loss it is effectively going to increase your share purchase price so that is something to keep in mind but there's a big mistake to avoid which happens when the stock price Falls if you enter a covered call position and the stock price Falls the good news is that the call option that you shorted will lose value since the stock price is falling and call options lose value as the stock price Falls so you'll have
a profit on your short call position but you will have a loss on your stock position the good news is that you can buy back that short call for a profit but the problem is what call will you sell next so if you want to consistently have a covered call position when you close your initial short call position you have to short another call in the same expiration or a different expiration to keep that covered call strategy going the situation you want to avoid is when you sell an underwater call which is when you sell
a call option with a strike price that is lower than your initial share price so if you bought 100 shares of stock for $100 per share and the stock price Falls to $80 per share you might not be able to sell a call option at the strike price of 100 or higher for any level of decent premium and so that would force you to choose a strike price that is lower than your initial share purchase price for example if you shorted the 95 strike call option when your share purchase price is $100 you would effectively
be creating a position where the best case scenario is selling your shares at $95 per share which of course is $5 lower than your initial purchase price of $100 so selling an underwater call is selling a call option as part of a covered call position where your strike price of the short call is below your initial purchase price on the shares and what that does is it creates a position where you're effectively agreeing to sell your shares at a price that is lower than your initial purchase price for those shares and that is not an
ideal situation personally if I were in this situation where I entered a covered call position and the stock price collapsed I would close that initial short call especially if it was trading for pennies on the dollar because I could close that short call for nearly a 100% profit which always makes sense but if I could not sell a call option with a strike price that is equal to or greater than my initial share purchase price then I would disc continue selling call options and discontinue the covered call strategy entirely until I could sell a call
option with a strike price that is once again at or above my initial share purchase price and to me this makes sense because if I'm entering a covered call position I should be comfortable holding these shares long term so discontinuing selling calls against the shares for a period of time is an acceptable approach in my opinion because I should be comfortable holding these shares for the long term and riding out that stock price decline which hopefully is temporary this is especially true if you're trading covered calls on something like spy which is the S&P 500
Index because over the long term a majority of the time the S&P 500 Trends higher and so if we are seeing a near-term correction in the S&P 500 discontinuing the covered call strategy for a period of time isn't the craziest thing because we can expect that eventually over the long term the S&P 500 where recover and we're just going to have to wait a period of time before we can sell calls that are higher than our initial purchase price for those shares of spy but if you're trading covered calls on a particular company and that
company's share price declines and if that stock price decline is because the fundamentals of the company have deteriorated then selling underwater calls or selling a call option with a strike price lower than your initial share purchase price could be a good exit strategy but if you're worried about the stock price to declining into the future then trading covered calls and holding the shares further doesn't make sense but that's really the only situation where I would say selling an underwater call is acceptable there is a simple strategy that you can use to recover your money quickly
when you're trading a covered call this simple strategy is called the stock repair strategy so what is the stock repair strategy well the stock repair strategy combines a covered call position with a bull call spread which is when you buy a call option and short a higher strike call option with the same quantity but in the same expiration cycle ideally you will set up this position so that you buy that call spread and short the extra call for a very small debit but you can potentially set it up for a credit which means you'll be
collecting money into your account as opposed to paying money for entering that portion of the strategy so I'm going to walk through a real example using block which has the ticker symbol s q because the company was formerly known as Square So currently the stock price is somewhere around $56 per share and has been declining rapidly over the past few months so let's go ahead and compare a simple covered call strategy and then set up the bull call spread with that additional short call and see how that changes the profitability that we can experience between
the covered call and the stock repair position so the simple covered call position would be buying 100 shares of stock and then short shorting a call uh shorting a call option and for this example I I will short the 65 strike call so I just click on the bid price for the 65 call we can see that this entry price is 5380 which is simply the share price minus the premium that we would collect for shorting the 65 call so the maximum profit we can see is $1,120 and the maximum loss is $538 which is
experienced if the stock price goes to zero so the um the call spread with the additional short call that I'm going to set up is the 60 65 bull call spread which means I'm buying the 60 call and shorting the 65 call but if I click on this 65 call and increase its quantity to two contracts we can see that this sets up a bull call spread with an additional short call which is technically a ratio spread but we don't need to concern ourselves with the names here we can see that this is trading for
a $148 credit the maximum profit is therefore $648 that's because the maximum profit on a $5 wide call spread the maximum value of a $5 wide call spread is going to be $500 at expiration but since we are entering this total trade for a $148 credit we add this $148 that we collect to the maximum position value of $5 for this spread at expiration and we get a Max profit of $648 so if we combine this whole position with the 100 shares of stock we can see that our maximum profit potential increases from the original
$1,120 which was the case for the covered call at the um 65 strike price or shorting the 65 call against 100 shares of stock versus the 1,400 $60 maximum profit for setting up this stock repair strategy the maximum loss does go up a little bit but it's not too much but the main thing here is that our maximum profit from this position is higher it's about 30% higher than the traditional covered call position so the stock repair strategy effectively buys a call spread but finances the purchase of that call spread with an additional short call
at that short call strike price so you basically buy a call spread and short an additional call at the short call shke price but for that position to not have unlimited risk to the upside you have to own 100 shares of stock if you don't have 100 shares of stock then that position would have unlimited risk to the upside because that additional short call would technically be a naked short call but if you own a 100 shares of stock then you buy a call spread and short an additional short call then that short call or
the naked short call would be covered by the 100 shares of stock that you own which makes it a safe position the downside of the stock repair strategy compared to the covered call is that when you're trading the stock repair strategy of combining the call spread with the additional short call you are spending a lot of the premium from that additional short call to buy that um bull call spread and basically what that does is it decreases the downside protection that you have as compared to a traditional covered call the trading software used in this
video was the tasty works brokerage platform which I have been using since 2016 so if you're interested in opening a brokerage account with tasty Works be sure to check the link in the description to secure their limited time promotion which will change from the time I've uploaded this video but currently it is a funding bonus depending on how much you fund your account with so be sure to check the link in the description for the most recent offer that's it for this one thank you so much for watching my name is Chris from Project finance
and I will see you in the next video
