A Simple Covered Call Option Trade
Simple recipes that can be created in just a little bit of time can be just as good as some fancy dish that takes hours of preparation, mixing, cooking, and carving. That is the way I feel about investing. Granted, there are some who would look down on my method as overly simplistic. I will let my results speak for themselves. I like what my covered call options recipe makes.
To that end, I want to step you through a trade that I did in Cindie’s ROTH IRA on January 4, 2023. Cindie owns 100 shares of Microsoft (MSFT.) When I saw that her shares were trading down, I decided to enter a trade that I consider to be relatively low risk.
Examination of the Dates and Dividend
First of all, I looked at the next earnings date and the upcoming Ex-Dividend date. The earnings date is the fourth Monday in January (01/23) and the Ex-Dividend date is 02/15/23. The next dividend is only $0.68, but I do want to have income that exceeds that dividend. I was hoping to get a premium that was at least $1.00, or $100 for her shares. The most she will get for the dividend is $68. The following image shows the 1) Equity Summary Score of 5.0; 2) Earnings information, and 3) Dividend information. This view was captured from Fidelity’s Active Trader Pro software.
Selecting the CC Sell Contract Price
Microsoft has weekly options. I don’t want the option to run past the earnings date of January 23, so I will either have to pick January 6, 13, or 20 for the contract expiration date. Because the shares were trading below $230, I decided I wanted Cindie to get no less than $240 for her MSFT shares. Therefore, the covered call price is ‘240’ in the following image.
Selecting the CC Expiration Date
Because January 20 is only three days before MSFT’s earnings reporting date, I don’t want to select that contract expiration date. That leaves only January 6 and 13. The bid price for the $240 January 6 contract is less than the $0.68 dividend. Therefore, although that would be a “safe” choice, I decided to go with the January 13 contract. Notice one important thing in the following image: the “Prob. Above 240 at Exp.”
Although there are no guarantees, I have found that picking a probability below 25% to be the best choice to prevent the shares from being called at the contract expiration. (This image was taken after I had already sold the CC contract for Cindie, so the “Est. Income” was not what Cindie received.) She received about $115. Had I waited until later in the day, I might have been able to get a better premium. I could have also entered an order asking for $130 instead of $115 to see if the contract might trade higher later in the day.
The Order Review Screen
The last of the series of Active Trader Pro images shows the order review screen. On this image you can see that a CC is called “Sell to Open.” The order shows the expiration date, the $240 contract price for the shares ($24,000), the “Limit” price of $1.34 and a TIF (Time in Force) of today. There are never any “conditions.”
Supply and Demand Matters
When buying stocks there are prices the buyer is willing to pay (called the BID), and prices the seller wants for their shares (called the ASK.) The same is true with options. If you have a Seeking Alpha subscription, you can see the BID/ASK prices for all of the MSFT options from $150 per share to $260 per share. Usually there is very little difference between the bid and ask price. In the following illustration, the bid price for the MSFT call option at $240 is $1.34 and the ask price is $1.39. As a general rule, I usually pick a price somewhere between the two. So, if I was selling a covered call based on this information, I would pick $1.38. You can always lower the price if you don’t get any takers.
Also notice that the “Volume” matters. This shows interest at various prices. For a stock like MSFT, I want to pick a contract price that has at least a volume of 500 contracts. In this illustration, for the $240 price, the volume is 5,128 and the Open Interest is 3,209. So this tells me there is quite a bit of activity at the $240 price. There are interested buyers and sellers of the MSFT call options.
According to Investopedia, “Open interest is the total number of open derivative contracts, such as options or futures that have not been settled. Open interest equals the total number of bought or sold contracts, not the total of both added together. Increasing open interest represents new or additional money coming into the market while decreasing open interest indicates money flowing out of the market.” LINK
Viewing the Option Chain Using Fidelity
It is also possible to see similar information on the Fidelity Investments website. If you go to News and Research or enter the ticker symbol MSFT in the search box on Fidelity.com, you will see some icons next to BUY and SELL. One icon that looks like a little chain lets you see the options chain. This image shows that link:
In the Money or Out of the Money?
The final image is also from Fidelity so that you can see the option chain. You should always know if the option you are selling is “in the money” or “out of the money.” An option is “in the money if the contract price is less than the current price of the shares. It usually doesn’t make sense to risk selling a covered call at a price less than the current price unless you are convinced that the shares will fall in price. I will always want the price of the contract to be higher than the current share price. That makes the option “out of the money.” That is just options-speak for “the buyer won’t like to buy your shares unless the price of the shares rises to $240 or greater. Then the contract will be “in the money.”
Tweaking the Fidelity Screen
When you are on the options screen, you can make changes. For example, you will see that I turned off all dates except for January 13. ‘C’ (above image) shows this. If the date has a light background it is NOT selected. If I wanted to see January 20, I would click on that date. Then I would see both January 13 and January 20.
If I only wanted to see the monthly (3rd Friday) options, I could use the slider next to ‘D’ to turn off weekly option dates. Then I would only see January 20 because that is the third Friday in January.
Summary
One of the keys to achieving success in trading covered call options is to look at the earnings date and dividend date before deciding to trade. Then you want to pick a contract price that is high enough to satisfy you if your shares should be called by the person who has your contract. I don’t want to sell my shares on the cheap, and I also don’t want the contract to active for a long time. Therefore, I usually want a contract expiration date that is no more than a month from today. Finally, I want to get the maximum profit from my covered call contract sale. In general, want at least $50 ($0.50/share) to make the 5-10 minutes of my time worth the effort.
Links for Learning
What is “open interest” in the world of options? Here is a helpful view of this from Investopedia: LINK
Think about the Higher Priorities.
You can spend a lot of time on your investments. That might not be very wise. If you are investing at the expense of doing good, loving others, and walking in humility, you are harming yourself, your family, and your church.
He has told you, O man, what is good; and what does the Lord require of you but to do justice, and to love kindness, and to walk humbly with your God? Micah 6:8
All scripture passages are from the English Standard Version except as otherwise noted.
Know Your Flocks & Herds 