Options Trade #5 - CVS Covered Call

Updated: Dec 6, 2018

VTS Community

Thanks so much for all the great feedback on the VTS Discretionary Strategy.  I'm glad to hear that those who are following along are enjoying it.  I always say most investing is boring and requires long-term patience and discipline, but I find option trading sits outside that as it can be quite fun.  I'm going on 13 years now and I still enjoy it.  The variety of trades we can open is only limited by our imagination.  Regardless of whether you're a rookie or veteran, there's always new things to learn.

So for anybody in our CVS trade #1 and sold the cash secured put at 67.50, you woke up this morning with 100 shares of CVS in your account at a cost basis of 67.50.  This is completely normal and part of the wheel of fun strategy.

Step 1 & 2 are now complete and we move on to step 3.  Sell covered call.  As a reminder, a covered call is an option we sell when we already own shares of the underlying.  Since we do hold 100 shares of CVS now, we can sell a covered call against that position.  If the price of CVS at expiry is above the strike price of our covered call we will lose the shares.

Now this may not sound like a good idea.  Why would we want to lose our shares?  The reason is because we will receive money  (a premium)  for agreeing to the contract.  As with all option trading there are plenty of choices as to which strike price we choose, but I'll go over the basic 4 that cover the full range:

Option 1:  In the money.  We own CVS at 67.50 but if we really do want to get rid of these shares while getting paid a little bit of premium in the process, we can sell what's called an "in the money" option which essentially means it's already well within the range where we'd lose the shares.

Example)  Sell 1x CVS 62.00 Call @ 4.10

-  Since the current price of CVS is 65.10 this means that if CVS is above 62.00 by the May expiry we would lose the shares.  We'd keep the 4.10 premium + the 2.00 premium we already received for selling the original put. 

Gain from premium:  6.10 Loss from shares:  5.50 Profit on the trade:  0.60  =  0.89% return on capital

Option 2:  At the money.  This means an option that is very close to the current trading price, either just above or just below depending on which one you favor.

Example)  Sell 1x CVS 65.00 Call @ 2.00

-  If CVS expires above 65.00 we will lose the shares and be out of the trade.

Gain from premium:  4.00 Loss from shares:  2.50 Profit on the trade:  1.50  =  2.22% return on capital

Option 3:  Out of the money.  Here we're selling an option that would require the underlying to continue moving in order to get called away.  This would be done when you feel the underlying still has some room to run.

Example)  Sell 1x CVS 70 Call @ 0.40

-  This would require CVS to make a decent move to the upside, but when you sell out of the money covered calls the potential for higher profit is there because you can make more on the actual shares.

Gain from premium:  2.40 Gain from shares:  2.50 Profit on the trade:  4.90  =  7.26% return on capital

Option 4:  Sell the break even.  This is a very common option for me to choose and it essentially means selling whatever contract corresponds to the original shares that we own.  Since we sold the 67.50 Put and now own the shares at that price, we would do this contract.

Example)  Sell 1x CVS 67.50 Call @ 0.95

-  Still requires a little movement upward in the underlying, but if we get called away it just means there's no gain or loss on the shares and our profit matches the premiums we brought in.

Gain from premium:  2.95 Gain from shares:  0.00 Profit on the trade:  2.95  =  4.37% return on capital

So there's plenty of options to choose from  (pun intended)  and that's what makes this type of investing so fun, and unique.  No two option traders have the same style.  So if you learn from me, and I'm happy to be your guide in this, you'd take what I teach you and then over the years there's always room to tweak it and find your own style.

I tend to be quite conservative in my investing so if you're a little more aggressive you can take what I do as a baseline and add a little risk to it.  Or if you're even more conservative you could move the opposite way.  

Learn the basics, get the fundamentals down and then branch out from there.  With experience perhaps one day you'll come back like Darth Vader in A New Hope like:  "When I left you I was but the learner.  Now I am the master."  Yes I'm a Star Wars fan  (except the newest ones)

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