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Your very first options trade

Your Very First Options Trade

Key Points
  • If you've never traded an option contract before, a covered call—selling a call in which you own a corresponding long stock position—is a way to ease into it

  • We walk through the process step-by-step and review potential outcomes.

When I teach options seminars, I like to ask how many participants are brand-new to options. Almost always, about half to three-quarters have never traded an option contract before. It strikes me that perhaps there's a non-stop stream of investors interested in getting started in the options markets, but perhaps many of them are intimidated and don't know where to start.

No option strategy is suitable for all investors, or even all options traders. For those who believe that options may suit their portfolio objectives, this article provides a step-by-step guide to help you accomplish two specific goals:

  1. Set up your very first covered call options trade.
  2. Possibly sell a very small stock position at a favorable price.

I also encourage you to read my articles about getting started with options and how to put options to work.

Do you have a long-term stock position?

If you have been an investor for any length of time, you probably have some equity (stock) positions in your account that you've owned for a long time. If the price was right, you might consider selling at least some of these shares. After all, unless your goal is strictly to get dividends, you probably bought this stock in the hope that it would eventually appreciate and you could sell it at a profit.

When first making the decision to trade options, successful stock pickers sometimes turn to long call options. Unfortunately, the results are often disappointing because both time and price can work against the owner of long calls and inexperienced investors my not be fully aware of the risks. Instead, I recommend covered calls as a first options trade because when structured properly, time and price can both work in your favor. Additionally, a covered call is generally considered a relatively low risk strategy, and approval to trade covered calls can usually be granted to investors that have never traded options before.

Let's look at how to set up a covered call.

Step 1: Identify the position

Step 1 toward executing your first covered call trade is to select a stock position in your account in which you already own 300 or more shares; the more shares the better. Make sure the position you select is trading at a higher price now than what you originally paid for it. For purposes of this trade, a stock that does not pay dividends, or pays very small dividends would be a better choice than a stock that pays large dividends. (For your very first options trade you will be selling only one covered call, and doing so on a larger position will ensure that you can continue to capture upside gains in the remainder of your shares, in case the stock experiences an unexpected sharp increase in price.)

Step 2: Determine price

After you've selected your position, you need to determine a price at which you would be willing to sell 100 shares of this stock, anytime within the next 30 to 60 days. In making this decision, it might help to view a one-year price chart. Let's assume that it is December 12, 2012 and you've chosen stock XYZ, in which you own 500 shares.

You only want to sell 100 shares if the stock's price returns to its peak, reached this year. As you can see in the chart below:

  • The current price of XYZ is $75.91.
  • The stock has traded within about a 10-point price range over the past 12 months.
  • The highest price that XYZ has reached over this time was around $77.80 in early May.
Your very first options trade

Source: StreetSmart Edge® 

You could attempt to sell 100 shares of XYZ at $77.80 by entering a GTC (good-til-cancelled) sell order at a limit price of $77.80 and then wait. If XYZ reaches $77.80 any time over the next 60 days, the shares will be sold. If it does not reach $77.80, the sell order will automatically expire after 60 days at Schwab. However, this is a regular limit sell order. So while it may meet your goal of selling some of your stock at a profit, it doesn't accomplish your goal of executing your first options trade.

Step 3: Consider a covered call

Another way to potentially accomplish both of these goals is to sell one covered call option on XYZ with a strike price near $77.80 and an expiration date 30 to 60 days from now. To determine if both of these goals are feasible, launch the Symbol Hub or Trade tool in StreetSmart Edge.

Your very first options trade

Source: StreetSmart Edge® 

(Note the numbered bullet points below correspond to the trade window picture below.)

  1. Enter the underlying stock symbol in the symbol box (upper left-hand corner).
  2. Click on the Options tab.
  3. Select "Calls" in the strategy window.
Your very first options trade

Source: StreetSmart Edge® 

  1. The only expiration date that falls within your 30 to 60 day window is January 19, 2013, (which is 38 days away). On that date, there is a call option available with a strike price of $77.50, which is fairly close to your $77.80 target price.
  2. Click on this contract, select "Sell to Open" for your Action and select your limit price ($1.02 in this example).
    1. If you want to change your limit price, you can use the up and down arrows next to the price, but for your first trade, consider just entering a limit price that is equal to the bid. This will likely result in an immediate execution and eliminate the need to wait for the stock price to change in order to get executed.
    2. Be sure you have also selected the appropriate quantity (“1” in this example and "GTC" for your Timing.
  3. Notice that the trading platform automatically calculates your Max Gain, Break Even, and Max Loss for this sale of one call option. However, because the system does not realize this is a covered call until it executes, these calculations do not include the sale of 100 shares of XYZ if you get assigned.
    1. Max Gain occurs if you get assigned and your stock is called away.
    2. Max Loss occurs if XYZ drops to zero, which is very unlikely. Your actual max loss would be -$7,489 (-$7,591 on the stock +$102 on the option)
    3. Similarly, the actual Break Even price of 74.89 is below the current market price, so this trade actually provides a small amount of downside protection, which comes from the 1.02 option premium.

Select the "Review Order" button. Then, verify the trade and place the order.

Your very first options trade

Source: StreetSmart Edge® 

When this order is executed you will have a short call position and receive a credit of $102 (before commissions are deducted). This call will automatically be "paired" as a covered call against 100 shares of your 500 share XYZ position. (Typical commission charges for this trade would be $8.95 ticket charge + $0.75 per contract or a total of $9.70).

Step 4: Wait

While it may be wise to occasionally review your positions, since you previously had no plans for selling XYZ, it is unlikely that you would need to do anything for the next 38 days but wait.

This $102 credit isn't free money. Option strategies are usually about making tradeoffs, and this is no exception. An option is essentially a contract, and once this order is executed, you take on a contractual obligation that you may or may not have to meet sometime over the next 38 days.

When you sold your covered call, someone else bought it, and that person (or anyone else holding the same call contract) has the right to exercise the call at any time until expiration. If he/she decides to exercise the call, he/she will buy your stock from you (this is called “being assigned”) and pay you $77.50 per share ($7,750 for your 100 shares of XYZ). However, doing so usually only makes sense if XYZ is trading above $77.50 in the market at that time.

The owner of the option can exercise it at any time, and you have no control over when/if that occurs. So it's important to be prepared to have your stock called away any time the option you sold goes “in the money,” that is, the stock price becomes higher than the option's strike price.

Beware of ex-dividend dates

The price of a stock is adjusted for normal quarterly dividends. This happens on the morning of the ex-dividend date—the first day following a dividend declaration when a stock buyer is not entitled to the next dividend payment. However, option prices are not adjusted for normal quarterly dividends.

As a result, when you sell a covered call on a stock that pays dividends, you are at risk of being assigned early if the call goes in the money. This assignment usually occurs exactly one business day before the stock goes ex-dividend. If the stock you select for your first options trade is a stock that pays dividends, take note of the ex-dividend date. If the option's expiration date is after the ex-dividend date, you must be prepared not only to potentially have your 100-share position called away, but also to lose the next dividend payment on those shares.

Option assignments take place after hours. If you are assigned, the transactions will be placed in your account very early in the morning (typically before you log in to your account). When you log in, you will see a sale of your shares and an assigned option transaction in the Transactions window of your Account Details screen.

Your very first options trade

Source: StreetSmart Edge® 

If the option remains out of the money (the stock price is lower than the strike price) you will not have your shares called away. Assuming you don't get called away early, let's explore what could happen if XYZ is at a few different prices when the option expires 38 days from now.

XYZ increases to $79 per share

  • You keep the option premium and your 100 shares of XYZ will be assigned (sold) at 77.50.
  • Your remaining 400 shares of XYZ have increased in value by 3.09 points.
  • Total gains = $1,497 before commissions ($102 + $159 realized) + ($1236 unrealized).

XYZ increases to $77 per share

  • You keep the option premium and your short call option expires worthless.
  • Your 500 shares of XYZ have increased in value by an additional 1.09 points.
  • Total gains = $647 before commissions ($102 realized) + ($545 unrealized).

XYZ remains unchanged at $75.91 per share

  • You keep the option premium and your short call option expires worthless.
  • Your 500 shares of XYZ have not changed in value.
  • Total gains = $102 realized (before commissions).

XYZ drops in price to $75 per share

  • You keep the option premium and your short call option expires worthless.
  • Your 500 shares of XYZ have decreased in value by -.91 points.
  • Total losses = -$353 before commissions ($102 realized) + (-$455 unrealized).

The table below compares holding 500 shares of XYZ and doing nothing (blue rows) to holding 400 shares and selling one covered call against 100 shares (white rows). Remember that the stock's starting price is $75.91 and the strike price of the covered call is $77.50. The first column (expiration price) shows some hypothetical prices for XYZ at expiration date and the last column (covered call impact) shows which strategy would perform better.

How do they stack up?

Expiration price of XYZ

Strategy

Covered call income

Unrealized gains or losses

Realized gains or losses

Realized+ unrealized gains or losses

Covered call impact

81

Stock only

n/a

$2,545

$0

$2,545

n/a

Stock + covered call

$102

$2,036

$159

$2,297

$(248)

79

Stock only

n/a

$1,545

$0

$1,545

n/a

Stock + covered call

$102

$1,236

$159

$1,497

$(48)

78.52

Stock only

n/a

$1,305

$0

$1,305

n/a

Stock + covered call

$102

$1,044

$159

$1,305

$0

78

Stock only

n/a

$1,045

$0

$1,045

n/a

Stock + covered call

$102

$836

$159

$1,097

$52

77

Stock only

n/a

$545

$0

$545

0

Stock + covered call

$102

$545

$0

$647

$102

75.91

Stock only

n/a

$0

$0

$0

n/a

Stock + covered call

$102

$102

$0

$102

$102

75

Stock only

n/a

$(455)

$0

$(455)

n/a

Stock + covered call

$102

$(455)

$0

$(455)

$102

74

Stock only

n/a

$(955)

$0

$(955)

n/a

Stock + covered call

$102

$(955)

$0

$(853)

$102

Source: Schwab Center for Financial Research

Looking at the table, you can see that:

  • An assignment (sale of 100 shares at $77.50) will occur at any price above the strike price ($77.50). The overall impact on the account is only negative if XYZ rises above $78.52 ($0.72 above its year-to-date high) because the 400 shares you still own can increase in price indefinitely, but the 100 shares on which you sold the covered call, will not be able to participate in any price increases beyond $77.50.

  • By contrast, for all prices below $78.52, the income received from the sale of one covered call will provide a net benefit to the account of up to $102, even when the overall account value declines.

What to remember about covered calls

  • Although the premium received from the sale of a covered call provides some downside risk protection, it does not eliminate risk entirely.
  • If the price of the underlying stock drops substantially prior to the expiration date, your losses could be significant.
  • If your short calls go in the money, you could be assigned at any time.
  • Anytime you sell a covered call, you have established a maximum selling price for your stock. Any movement in the stock beyond that established price creates no additional profit.
  • It is rarely a good idea to sell a covered call if your stock position has already moved significantly against you. This could cause you to establish a closing price that ensures a loss.
  • While the example above assumes that you hold the position(s) until expiration, you can usually close out a covered call at any time by buying it back at the current market price.
  • Early assignment usually occurs exactly one day before the ex-dividend date.

Test the waters

While options trading can be complex and the variety of trading strategies is virtually limitless, the options market doesn't have to be intimidating. For many traders, options can provide a sensible and effective way to generate modest amounts of income or try to hedge against market and portfolio risk.

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Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab. Please read the options disclosure document titled Characteristics and Risks of Standardized Options before considering any option transaction. Call Schwab at 800-435-4000 for a current copy.

Covered calls provide downside protection only to the extent of the premium received and limit upside potential to the strike price plus premium received.

Schwab does not recommend the use of technical analysis as a sole means of investment research.


Past performance is no indication (or "guarantee") of future results. The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice.

Commissions, taxes and transaction costs are not included in this discussion, but can affect final outcome and should be considered. Please contact a tax advisor for the tax implications involved in these strategies.

The information presented does not consider your particular investment objectives or financial situation, and does not make personalized recommendations. Any opinions expressed herein are subject to change without notice. Supporting documentation for any claims or statistical information is available upon request.

The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. Examples are not intended to be reflective of results you can expect to achieve.

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