With the market now moving in a rather sideways trend, investors are wondering should they start trading to lock in the gains from the top and bottom or should they just hold tight and wait. With covered call options, an investor can adopt the Double Income Covered Call Strategy to generate a consistent stream of monthly income. In this article, I will be explaining how to use this strategy as well as the potential risks you might take on.
What Are Covered Call Options
To understand and apply this strategy, you must first understand what is a Covered Call. A covered call is when an investor is selling call options while owning an equivalent amount of the underlying security. To execute this, an investor holding a long position in a stock then writes (sells) call options on that same asset to generate an income stream through the premiums collected. The investor’s long position in the stock is the “cover” because it means the seller can deliver the shares if the buyer of the call option chooses to exercise.
Read More: Understanding 2 Important Options Strategies For Beginners (Sell Covered Calls)
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Double Income Covered Call Strategy
Now that you understand what is a covered call option and how it works, you can start using the Double Income Covered Call Strategy. Let’s start off with the requirements for applying this strategy.
Requirements
To execute the strategy, here are the 2 simple requirements:
- At least 100 shares of a stock
- Expect the stock to move sideways in the short term
Execution and Explanation
Once you have chosen the stock you want to perform the strategy on, you can start looking at which specific option to sell the covered calls with. You ideally want to find options that fulfill these criteria:
- 30-45 Days to Expiry (DTE) as it offers a good premium as time decay states to accelerate
- Strike Price above Average Cost Price
- Fairly Out of the Money (OTM)
So how does this strategy work? Let’s assume you have 100 shares of AAPL with an average cost of $120 per share. You will first look for options expiring in 30-45 days. You will then look at selling covered call options that are around 5-10 spreads above the current price ($130) as they offer a relatively attractive premium while giving you good odds that the share price will not cross the strike price.
Let’s say you think the share price won’t go higher than $140, you will then sell covered call options with the $140 strike price. Based on the current option chain, you will receive $ in premiums. This acts as your first stream of income.
When To Close
After you have sold/written your covered call options, you have 2 options, to close the options early and lock in gains or to hold it into expiry. Doing the former will allow you to lock in early gains but there is a low chance of you securing maximum profit as compared to the latter which almost guarantees you near-maximum profit but you do run the risk of making a loss should the share price go against your favor during the last few days before expiry.
If Your Covered Call Gets Assigned
In the best-case scenario, your covered call options will almost never get assigned but, of course, the market is always unpredictable. This is why, in this strategy, you always set your covered call options at strike prices above your average cost. This way, if you do get assigned, you still get to lock in some capital gains, which acts as your second stream of income in this strategy.
Risks
This strategy sounds perfect in theory but, as with every single option strategy, there will always be risks. Here are 2 key risks that you may face when applying this strategy.
When The Share Price Goes Up Substantially
When the share price goes up substantially, you don’t lose money per se but rather, you cannot enjoy the full upside of the price movement. As you know, your maximum profit is capped at the amount of premiums you received.
As such, if the share price goes way above your strike price, your maximum profit is equal to the difference between the strike price and your average cost price plus the premiums you received.
Therefore, if an investor has a rather bullish view on the short term, you are better off with simply buying calls or holding the shares directly.
When The Share Price Goes Down Substantially
Similarly, when the share price goes down substantially, you don’t lose money per se but rather, you might face unrealized losses that might be bigger than the premiums you received.
As such, if the share price goes way below your average cost per share, you get to keep the maximum profit which can be used to offset your losses because it goes into lowering your average cost per share.
Therefore, if an investor has a rather bearish view on the short term, you are better off with simply buying puts or selling the shares directly and applying a different options strategy to maintain a long-term bullish view.
Final Thoughts
All in all, the Double Income Covered Call Strategy, is perfect for a sideways market like what we are facing right now because it allows you to collect a consistent stream of income almost every month. Although the strategy sounds perfect in theory, investors must exercise caution and understand when it is best to apply this strategy to maximize your profits while minimizing your risk.