Trading Options: Covered Calls on thinkorswim®
Upbeat music plays throughout.
Narrator: If you're looking to trade options, or even if you're just curious about what options are, you've come to the right place. By the end of this video, you'll understand how options work and know how to place your first options trade on the thinkorswim® trading platform.
We're going to walk you through step by step on how to place your first options trade. Options aren't for everyone. But for those with the risk tolerance and time to learn, they're a highly customizable and powerful instrument that can allow you to potentially profit in any market conditions: up, sideways, or down.
With options, you can do things like speculate, hedge, or generate income. You can also place trades with a wide range of risk levels and probability of success.
Here's what we'll cover when it comes to options. First, we'll dig into what options are and how they work. Next, we'll walk through a basic option trading strategy, the covered call, and then I'll show you how to place your first options trade on the thinkorswim paperMoney® platform, a powerful trading simulation tool that allows you to practice without the use of real money.
On-screen text: What is an option?
Narrator: We're going to cover some technical terms and definitions here but stick with me. Getting this foundation will make it clear why options can be so powerful.
So, what is an option?
Animation: Trader A is an options buyer. The option contract includes a quantity (100 shares), an underlying (XYZ), a strike price ($50), and an expiration (Jan 17th).
Narrator: It's a contract that gives the owner the right or the option to buy or sell a specified number of shares of a stock, ETF, or another predetermined underlying at a certain price on or before a certain date. But why would you want to do that? Basically, it can give you more ways to potentially profit from stocks whether you own them or not.
An option is what's called a derivative. That means the option derives its value from what's called an underlying security like a stock.
There are two types of options: calls and puts. Calls allow the option buyer to buy the underlying at a certain price. So, buying a call is bullish. You want the stock to go up. Puts allow the option buyer to sell the underlying at a certain price. So, buying a put is bearish. You expect the stock to go down. But you can also sell options.
On-screen text: Call option sellers are obligated to sell the underlying at a certain price and put option sellers are obligated to buy the underlying at a certain price.
Narrator: So, selling a call is typically bearish, while selling a put is typically bullish. Each option contract usually represents 100 shares. This is known as the options multiplier.
That's a lot of information. So, let's look at an example of buying a call option to help show how it actually works.
Let's say a stock, XYZ, is trading at $49 a share and Trader A is bullish on it. She thinks the price will go up over the next month. Trader A could just buy some shares of stock, but she could also buy a call option if she's not interested in actually owning the stock.
So, a call option lets her speculate on the stock's future movement without actually having to own the stock. Trader A buys a call from Trader B, who doesn't think the stock will go up. Buying this call earns Trader A the right to buy the shares of the stock from Trader B at an agreed upon price, called a strike price, by a certain date, called expiration.
For this example, let's say the strike price is $50, and the expiration is one month from now. Trader A is hoping the stock will go above $50 in the next month, which would make the right to buy $50 valuable. But we'll talk about potential outcomes in a minute.
In exchange for the right to buy shares at $50, Trader A pays Trader B what's called a premium. Premium is just another word for the price of the options contract. In this example, we'll say it's $2. Because a standard option contract controls 100 shares of the underlying asset, the total premium is $2 times the option multiplier of 100, or $200 per contract. This does not include transaction costs, typically a contract fee paid to the broker.
So as the seller of the call, Trader B collects $200, but they're obligated to sell 100 shares of XYZ at $50 each if Trader A exercises a right to buy, which could happen at any time in the next month before expiration. Notice the difference. The buyer of the call has the right to buy the shares and the seller of the call has the obligation to sell them.
Trader A doesn't have to exercise her right. If she doesn't, Trader B won't have to sell. But if Trader A does exercise her right, Trader B must fulfill his end of the deal and sell the shares at $50 each. The option seller having to fulfill their obligation is called assignment. Looking at different ways this trade could go will help us see how this all fits together.
Let's say the stock price jumps to $53. This would make the option be what's called in the money. That means Trader A could exercise her right to buy the stock at $50, a $3 discount per share. You can see why buying a call option is bullish. If the stock goes up, the call buyer has the ability to buy the stock for less than it's worth. Trader B, on the other hand, would have to sell the shares at a loss, though they would keep the $200 of premium.
But what if the stock drops to $48 per share before the contract expires? In this case, the option would be what's called out of the money and would expire worthless. Why would Trader A want to buy a stock at $50 if she could buy it for $48 on the open market? Trader A loses the premium she paid for the option. This is the desired outcome for Trader B, who sold the call. The seller hopes the contract will expire worthless so they can keep the full premium, in this case, $200.
Now, there's a crucial thing to note. The example we just looked at shows what would have happened if Trader A wanted to exercise her right to buy the stock and waited until expiration to do so. But many options traders don't actually intend to buy or sell the underlying. Options contracts fluctuate in value and can often be bought or sold before expiration for a profit or loss.
So, option buyers often buy the option hoping it will increase in value so they can sell to close the position for a profit before expiration, and option sellers often sell the option hoping they can buy to close at a much lower price or let it expire worthless and keep the full premium.
The other important thing to understand is that the price of the underlying stock is a big factor in the option's value, but it isn't the only one. Time to expiration and the underlying stock's riskiness, known as implied volatility, matter too.
To help clarify how these factors work, we'll look at put options and compare them to something you may be more familiar with: car insurance.
With car insurance, the underlying asset is the car. The more valuable the car, the higher the premium. If you insure a Porsche, you'll have to pay more than you would with a Honda Civic. Time is also a factor. Some choose to pay car insurance every month, while others pay every six months. The longer the time, the higher the premium.
And don't forget about risk. Insurance companies look at certain characteristics of drivers to determine how risky they are. For example, teenagers are usually considered riskier than, say, more mature, responsible drivers. Much to parents' dismay, an insurance contract will likely be more expensive for teenagers. These factors are very similar for an options contract.
The price of the underlying asset is the most significant factor. Options tend to be more expensive when the underlying stock costs $700 dollars rather than $10. Also, time is an important element. The more time between now and when the option expires, the more expensive the contract.
And lastly, there's implied volatility. Some stocks and ETFs are riskier than others. Some stocks, like biotechs, for example, could be considered the teenagers of the investing world, while blue chips, with healthy dividends, are more like mature, stable elders of the market.
On-screen text: Introducing covered calls
Narrator: So now that we've covered the basics of how options work and how you could potentially profit from them as a buyer or a seller, let's dive into one strategy in particular: covered calls.
The covered call is a common starting point for new options traders because it combines call options with stocks you already own.
So, what is it? Generally, the goal of a covered call is to generate income by selling out-of-the-money calls on stock you already own. As the option seller, you hope the option decreases in value so you can buy it back for less or let it expire worthless, so you get to keep the premium and the shares of the stock.
But remember, as the option seller, there's the possibility of getting assigned and being obligated to sell the stock. The stock you own can limit risk and serve as collateral.
If you get assigned, the stock will automatically be sold to fulfill your obligation. Because of that assignment risk, don't consider this strategy unless you'd be OK with selling those shares of stock if the trade doesn't go your way.
In fact, some traders use covered calls as a way of exiting a stock position they already plan to sell because it can earn extra income along the way thanks to the option premium. But for now, we're going to focus on using a covered call as an income-generating strategy, selling contracts we hope expire worthless.
Let's look at an example. Suppose a trader holds 100 shares of stock XYZ, which she bought at $46 a share. Let's say she sold a call with a strike at $48 that expires in 30 days. She earned $100 in premium on the trade. Since she bought the shares at $46, the break-even point is $45, $46 minus $1 for their premium. The stock falls anywhere from $46 to $45. The premium will offset the losses and the trade would still be profitable. But if the stock drops lower than $45, she would start to lose money.
Let's say the stock goes up to $49 a share at expiration. The option would be in the money and there's a good chance it would be exercised. That means she would be forced to sell those 100 shares. She'd keep all of the premium, $100, and the profit from the stock sale at the strike price. Remember, she agreed to sell the stock at $48, which is $2 above where she bought it at $46. That's another $200 in profit for a total of $300 gain.
One thing to keep in mind is that there is a risk of missing out on further gains if the stock goes up even further. But what if the stock only goes to $47 at expiration?
In this case, the option is out of the money and would expire worthless. Why would another trader buy the stock at $48 when they could buy them at $47 on the open market?
In this case, she'd keep the full $100 of premium plus $100 worth of price appreciation in the stock she still owns for a total profit of $200 minus any fees.
So now that you've seen how covered calls work, let's break down how you actually trade them. Trading a covered call comes down to a few key decisions.
First, choose an underlying. Some stocks may be better suited for covered calls than others.
Next, choose an options contract. This has two parts. One, choosing an expiration or how long the option will last, and two, choosing a strike price.
Once you've chosen a contract, you need to determine your position size. How many contracts will you sell? This depends on how many shares you own or how many you would be willing to sell if you get assigned.
To walk through these decisions, let's log onto our trading software, thinkorswim paperMoney.
We'll notice up at the top left it says PM for paperMoney and SIMULATED TRADING. This allows investors to practice a covered call or any type of strategy in a paperMoney account. It's not real trading. So, it's nice to be allowed to really learn strategies where there's not the pressure of real money.
In this example today, we're going to look at the Monitor tab, which is the first tab, and we're going to go down and we're going to look at what's called the Position Statement. The position statement just simply states the positions that are in this paperMoney account. And we can see down below we have Boeing, JPMorgan, PayPal, and also a company called Zoom, ticker ZM.
For our first example, we're going to take a look at JPMorgan, ticker JPM. And you'll notice in this paperMoney account, there's 100 shares of stock. And what you'll notice is you can click on that little triangle right there, collapse or expand and show what is the position. The position has 100 shares of stock.
Now, if you remember, to do a covered call, the investor needs 100 shares. The trade prices was $98.88 and the current price, known as the mark, is at $102.03. So, you'll notice if you go over to the right, we're going to see in this column where it says Profit/Loss Open. This stock is up an unrealized gain of $314.70. So, if the investor has 100 shares and the stock is above support in an upward trend, that investor can consider to do a covered call position.
Second, the investor would want to go look at the Charts tab, where we can visually see what that trend looks like and if that stock is above support. So here we can go to the top left. We can type in JPM. And if we do that and press enter, we can see the chart of JPMorgan Chase. We see down at the bottom that this is really a chart looking in the last couple of months since January.
What we will notice is on the chart, we do see support levels. Think of support like a floor, maybe right around about the $80 level. Maybe about another level, let's say about $90 or so, and then maybe even recently, maybe right around about $95. It is a bullish strategy, so the investor needs to see proof that the stock is actually holding above a support and the stock is actually even been recently been making some higher highs.
So, if the investor considers to do a covered call on JPMorgan, they can now go to what we call the Trade tab. The Trade tab is just found to the right of the Monitor tab, where we were before. We can now type in the symbol JPMorgan.
Now, we're going to actually take a look at right underneath JPMorgan, the ticker JPM, we see Underlying. Underlying is just another word for stock. We can see the stock is trading at $101.91 today, up $0.58. And this up top is really the stock information. But we're looking at applying a covered call.
So, when we talk about doing a covered call, we're going to now go down to what's called the Option Chain. The option chain is really going to give us a variety of different strike prices and expirations.
First off on the left-hand side, we're going to see two different colors, one kind of a goldish color, and another color, this white color. The gold or yellow color really represents what we call weekly options, and this is really reading that this option expires the 4th of September, 2020, has zero days to expiration.
If you put your cursor right on that, it will tell you how many days there are to expiration. Today is expiration. This has 100 shares in the contract. And like labeled, we can see that these are weekly options. The ones that are in this white font we actually see that these are what's called the monthly options, and we'll start here. But you'll actually see that these expire on the 18th of September, 2020, and that's 14 days left to expiration. And again, you could put your cursor on that.
The investor could click on that triangle right there. If we click on that triangle, that will expand it, so we can see which strikes this option expiration has. First, so we can see what's going on, we can see on the left-hand side is calls and on the right-hand side is puts.
And what you'll notice is, the investor can also pick which strikes they want to see. This is now showing four strikes, and the strikes are right down the middle of the page. We can see the $101, the $102, the $103, et cetera.
Now, what the investor could do is if they wanted to see a couple more strikes for their picking of which strike they want to sell, they can now maybe click on, let's say, click on the dropdown and maybe even go to, let's say, 6.
So, now what you're going to see is, when we look at the left-hand side, again, we're talking about a covered call, we're talking about selling calls, we're going to focus our eyes really on the left-hand side. And now what you're going to really be seeing is a little difference here between why are some options shaded and then why are some options not shaded.
Well, the ones that are shaded, OK, the $99 strike down to the $102, those options are shaded because those options are in the money. That just means the stock price is above those strike prices. The strike such as $103, the strike such as $104, those options are out of the money. That means, in that case, the current stock price is below that strike price.
Now that we've looked at the option chain, let's actually now take a look at the decision-making process. Number one, looking at the option expiration that you want to sell. Number two, which strike is the investor going to actually sell?
So, let's first tackle which expiration month. If the investor decided they wanted to have less chance of the stock to close above the strike, they could pick the option expiration that has the shorter number of days. If they do that, the investor is actually wanting the time to be on their side where there is less time for the stock to get above the strike that they sell.
If the investor were to say, "Hey, I want to actually try to sell more time." Well, clearly, that would be more time for the stock to go up and potentially get above the strike that they sell. So, if the investor wants to have a greater chance of keeping the stock, they'd probably sell an option that is closer to expiration, like 14 days.
If the investor said, I'm OK with actually having more time for that stock to potentially get above the strike and I don't mind if those shares are assigned to somebody else, they could actually sell an option that was farther out. Also remember when the investor sells an option that is shorter dated, the premiums are going to be typically smaller because there's less time than if someone were to actually sell an option farther out in time.
So, when we pick an option expiration month, we typically look for options they have 20 to 50 days to expiration. And the rationale behind there is we want to make sure that there is enough premium, but not too much time for the stock potentially to close above that strike, so it's a balance between the premium and time.
Number two, we want to now talk about the strike selection. So, when an investor really looks at the strike, we're going to go up over on the left-hand side to where it says CALLS again. And right below where it actually says CALLS, we're going to click on the dropdown. We're going to drop down to where it says Option Theoreticals & Greeks.
The option greeks are really measurements of sensitivity. The option greek delta can also be used as a proxy or a way to find out the probability of a stock to close in the money.
So, what you'll now notice is, with each one of these strikes, there is a probability associated with the stock closing above the strike.
Let's stay with the 18th of September right now. What you'll notice is, if the investor were to sell the $102 strike, the probability of the stock closing above that strike by a penny is 52. If the investor were to sell the $103, 47% chance to close above the $103. And if the investor were to sell the $105, what you'll notice is it's a 38% chance.
So, what you'll notice is there's a correlation here, higher probability of closing above the strike price. There is also a higher premium. Lower probability of closing above the strike price, lower premium. So, remember we said in rule number one is taking a look at the option expiration month. The investor could start with looking at options 20 to 50 days. So, these options only have 14 days.
Let's go ahead and close that by clicking on that triangle right there, and let's go down to the option expiration that has 20 to 50 days. The 16th of October has 42 days to expiration. And second, when the investor is actually considering which call strike to sell, the investor's typically looking at the strike that has a delta, again, think probability, the delta of 30 to 40.
Now remember, what does that mean again? If this delta says 31, that's saying the likelihood of the stock closing above the strike price. So a 31% chance to close above, which means a 69% chance to close below that. Now, when the investor actually goes and also looks at the bid and ask, how does the investor know what to click on?
Well, remember, if the investor is buying an option, and as we hover our cursor right there, you're going to see right below that arrow it says Buy. Well, we're not buying a cover call. We're selling a covered call. We're selling the call.
So, we're going to go over to where it says the 2.64, right below that arrow. It says Sell. If the investor, number one, picked 20 to 50 days to expiration, that's the expiration month we're in with 42 days to expiration. Number two, if the investor were to pick an option strike with a delta of 30 to 40, OK, which is, in this case, the 110. And the premium in the bid column shows $2.61.
Remember as we talked about before. It's not just $2.61. We need to times that $2.61 by 100 because the investor has 100 shares of stock. So, this is actually $261.
Now, if the investor wanted to sell the call, they click on the bid column on the strike price that they want to sell. If the investor were to click on that, you're going to notice that down below, a red horizontal line appears. That red horizontal line is an order to sell. It's in red. We know it's also to sell because it says minus 10. Now, this is not the number of shares. This is showing the number of contracts. And remember, if the investor had 100 shares of stock, they would not be selling 10 contracts. They would only be selling one contract.
So, we could simply just adjust this up or down, and we're just going to change to where it says minus one because the paperMoney account has 100 shares. Now, if we read across, we're going to sell minus one JPMorgan. The option expiration is the 16th of October. The strike is $110. And remember what that really means. That means that this paperMoney account is obligating itself to sell those shares from now until expiration at $110. That means the investor can make from about $102ish up to $110, which is $8, and also get the premium of that $2.61.
You'll notice also where it says Order LIMIT. Limit is saying you want that price or higher, but not lower, OK? Could be filled for higher, though. Before we actually send this order, let's remind ourselves of what the paperMoney account really bought the stock for. You're going to see that right above here, it's going to say Position. Let's click on that. And it's going to show the position that's in the paperMoney account, just like we saw before on the Monitor tab.
Where we want to go with this is we want to really be able to see what is the maximum gain, what's the breakeven, how much can the stock go down. Well, in this case, remind ourselves that in this case, the trade price was $98.88. So, let's think this through. If the investor owns a stock at $98.88 and they have an obligation to sell the stock at $110, that's about $11.12 of stock appreciation. But the investor also gets the $2.61. So, the investor gets the $11.12 and they also get the $2.61.
And so, in that case, the investor would get about $13.73 of maximum gain, which is actually pretty good for a stock that's only $98. Now, in this case, let's say the stock were not too close above $110. Well, if the stock were not to close above $110, and let's say the stock stayed exactly flat from where it is right now, the investor only would get the premium, OK? And why is that?
Well, remember, the investor agreed to sell the shares at $110. But if the stock price in the current market is not $110, it is highly unlikely that someone is going to want to buy the paperMoney account shares if the stock is trading below that strike. So, if the stock were not to close above that strike, the investor gets to keep all of that $261.
Lastly, if the stock were to go down, that down move in the stock can be offset by some of the premium. So, if the investor bought the stock at $98.88 and got a premium of $2.61, the breakeven on the stock is at $96.27. So, what's nice is if the stock goes up quite a bit, the maximum gain would be $1,373. If the stock were to go sideways and stay completely flat, nothing happens. The investor gets $261. Why are they getting paid that $261?
Because of the obligation for selling those shares at $110 and for their time.
Wouldn't it be nice to actually get paid for that obligation? That's why investors like to consider selling covered calls, because sometimes that stock doesn't close about the strike, and that allows the investor to also reduce their average price in which they own the stock.
And lastly, if that stock were to go down, the breakeven to the downside is $96.27. Now, if the investor went down to the bottom right and said, let's Confirm and Send this and read the order together. Let's remind ourselves that this is a paperMoney demonstration. It's a simulation, not a real trade. The one thing that this does not take into account is that the paperMoney account already owns the shares already. This is thinking that the paperMoney account is selling not a covered call, but a naked call, which is where the investor doesn't own the shares.
This is a covered call because the paperMoney account has the shares. We can now look at this where it says the credit, the $261. And what is the commission? The commission is $0.65 per contract, and you're going to see that debited from the credit, leaving a credit of $260.35. If that's what the investor wants to do, they can now come down and click on the Send button. And if the investor clicks on the Send button, it's going to go out and try to sell that option.
Now, notice what's happening below. Remember, a covered call is two lines. The first line is the 100 shares of stock. The second row is really the call, which just filled, and it says minus one. Why does it say minus one? Because it's a sold call, 42 days left to expiration.
So, we can see that the premium is $2.61. But remember, we need two times that by 100, the option multiplier. So that's $261. And the mark value right now is $2.55. And remember, what the investor would like to do is sell that call when it's high and potentially buy it back when it's low. This is our first covered call, so well done.
So, we can see on the 16th of October, we have a position in our first covered call at the 110 strike. It says POS for position. But where do we really see the position in the entirety? Well, what we could do is we can go up to the Monitor tab. The Monitor tab monitors the positions and states the positions in the account.
So, we can now see the JPM by simply clicking on the triangle to the left of the ticker symbol JPM. Here's JPMorgan. We see that we have the stock and the sold call that we just did. But what about other covered calls that have already been going on for a while?
Let's take a look at another position where we can see what happens after a while in some of these positions, and let's start with the ticker BA, also known as Boeing. So, as we go up to the left-hand side of Boeing, we can again click on the triangle. That will expand and we'll be able to see the shares. We'll also be able to see which call was sold.
So again, let's kind of really walk through what this is really showing. So, number one, 100 shares of stock. The trade price was $176.22, and the current stock price, and sometimes this happens, it's lower than where it was traded. It's at $167. And what you'll notice is, all the way over to the right, is we can see that the stock position is down $837. That's not great. How do covered calls play into this?
Well, if the investor maybe thought that the stock might not close above the strike price and they decided to sell a covered call, well, in this case, that's what the paperMoney account did. The investor sold the 11th of September, the $185 call. We know we sold it because it says minus one. And what you'll notice is here is we see that there is seven days left to expiration. Now, what I want you to recognize is what is the strike price. Well, it's $185. What is the current stock price? It's $168.
Now remember, when an investor does a covered call, any time, from the time the investor sells the call until expiration, not just expiration, but any time up till expiration, someone can buy the shares of the stock even though it's prior to expiration. So, if the stock is at $168 and the strike or the obligation is at $185, do you think someone's going to want to buy these shares at $185 if the stock price is $17 below that strike price? Pretty unlikely, right?
Now, what you're going to notice is when the investor sold that call at $185, the premium that was received was $11.32. But it wasn't just $11. It was—times that by 100 again for the option multiplier—it was $1,132. That's quite a bit of premium for just 100 shares of stock. Now, what you'll notice is the mark price, or the current value of the option right now, is $1.31. Now, what you'll notice is the option was $11.32 and now it is $1.31 or $131. So, what causes the value of the call the change in price? Well, in this case, if the call option value declined in value, that means the stock probably went down, and it did.
Number two that what actually caused the option value to decline in value is the time decay. And what you'll notice now is over to the right, we can see the Profit/Loss Open for this option, $1,001. Now remember, when the investor sells a call, they can only get a certain amount of premium that was received, the $11.32 or $1,132. Currently right now, this position is sitting in a profit of 88% of the premium. So, what that really means is if the paperMoney account were to exit this option, it has about 88%, or $1,001, of the $11.32. So, in this case, the investor now could decide do they want to stay in this option.
Well, what would make them consider to maybe potentially stay in? Well, one question is, how much option premium is left. Well, how does the investor get that last $131? Well, the investor would have to wait the next seven days to see if the stock were to close below the strike. And if that stock were to close below the strike, the investor would not get some of that $11.32. They would get all of the $11.32. If they think that there's a good chance the stock won't close above that $185, they could just let this option erode in value and want the stock to close below that strike of $185.
And remember, where's the current stock price right now? It's at $168, so that stock, in the next seven days, would have to go from $168 to $185. If it doesn't do that, the investor could pick up another $131, OK, and that could be at a potential full maximum gain of that $11.32. So, this is an example of an option that is out of the money, meaning the current strike price is above the current stock price, and there's probably a high probability of this stock not closing above that strike price. But what happens if the stock is above the strike?
Well, let's go look at an example together of the ticker ZM. Now first off, let's just kind of take a look at where did the paperMoney account buy the shares. Well, the paperMoney account bought the shares at $242.56, and the stock price is way higher than that. Now, you know that in the COVID-19 environment, a lot of people have been using Zoom technology for their conference calls, so the stock has had a big move to the upside.
Now, what you're going to notice is that stock profit and loss is up $12,169. But what you'll notice is here, when we go take a look at, let's say, the call that was sold, the call that was sold was the $277.50 strike price. But wait. Where's the current stock price? Well, the current stock price is at $364. But what happens in this situation?
Remember, when the investor sells a covered call, they obligate themselves to sell those shares at $277.50. And with the stock so much higher than that strike price, we probably know there's a very high likelihood that this paperMoney account is going to be losing these shares of stock, OK?
And let's kind of talk about that. If, for example, someone did not care in selling these shares of stock, they could just let this trade close above the strike price. And if that stock were to close above the strike price, then the 100 shares that are in their portfolio would be sold at the strike price of $277. What does that mean?
Well, that means that the investor gets from $242.56 up to $277.50. Guys and gals, that's about $33ish or $3,300. But remember, that's not all. The investor also gets the premium on top. So, they get the stock appreciation from $242.50 or so to $277.50, $35. And the investor also gets $7 additional on top. So, the investor gets about $3,500 of appreciation and $710 in premium, for a total of about $4,200. So don't feel bad for the paperMoney here. The paperMoney account is still going to walk away with about $4,200 or so.
On-screen text: Disclosure: A short option position that is in-the-money prior to or at expiration has a high likelihood of being assigned, but it is not guaranteed to happen.
On-screen text: Disclosure: IMPORTANT: The paperMoney virtual trading application will not assign a short option position early, which is different from a real trading account.
Narrator: So, option number one, if the investor was OK with that, the investor does not need to do anything. They could just let the stock close above the strike price. If that were to happen, the paperMoney shares of those 100 shares would be gone at any time from now until expiration.
But I wonder if the investor actually said, "No, I do not want to sell those shares at $277.50."
Well, let's now kind of talk about the option premium. Well, remember, the trade price on that option was $7.10, or $710. The mark value or the current value of the option now is $86.50. This is different than what we saw before. The option value appreciates when the stock goes up. So, if the investor were to let this close here, OK, and let's say today was expiration, these shares would be taken. But if the investor said I don't want these shares taken, they now have the choice to buy that call back.
Now, if they buy the call back, they're not doing so for a gain, because that call is losing $7,940. But wait. Did the overall covered call position make or lose money? Well, remember, the stock position is up $11,800. The call is actually down $7,940, for a net of $3,887. If the investor decided they did not want to sell those shares of stock at the strike price, they could simply right click on that line, on the strike price, right click anywhere on that line. They could then go to Create closing order. And what this is really doing is it's buying the call back.
Now, when they buy the call back, they're releasing themselves of the obligation to sell the shares at $277. So why would an investor do this? The investor that buys the call back is thinking that the stock could likely go higher. And that way, they don't have to sell those shares at $277.50. If the investor picked that top line right there, buy that Zoom call at $277.50, they're buying the option back at a higher price. Note it.
And now once that does that, it now takes us to the Trade page. The Trade page is where the investor can see buying the option, plus one contract because it was sold initially. And now what you can see in this case is the investor is buying the price, buying that call back, for a price at $86.20.
Now, in this case, we would want to go look at what's the mid-price. The mid-price is really in between the bid and the ask. Now, if the investor just wanted to hurry and get out of that call, they could probably have a higher chance of being filled at the higher price, of course.
But if the investor said, "You know what? Don't want to pay that much for it. Want to try to get a little bit better price." The mid-price, again, is just between the bid and ask on the option price. The investor typed in $84.80, and again, limit, that says that's the most the investor is willing to pay to buy this option back. If that's what the investor wanted to do, remember, this is not $84.80. This is $8,480. Remember the option multiplier.
Now, the investor might be shocked by that. But you have to remember that the gain also is coming from the stock. So, the stock gain is paying for the loss in that option for a net of about $4,000. If the investor is OK with that, they can go down to Confirm and Send.
Remember, the cost of the trade is what the investor is buying that option back for, $8,480, and adds $0.65 per contract for the commission.
Now, if that's what the investor would like to do, they can now send this order. And when they do that, what it's actually going to do is it's going to try to go out and buy that option back. Let's go back to the Monitor tab.
So, in this example on Zoom, some things to note here. Is it a good idea that the investor waits until maybe the last second or the last day to buy the option back? Maybe not necessarily. Typically, investors maybe would look inside four to 10 days prior to expiration and make the decision if they want to buy that call back. If they buy the call back, they're really saying they want to keep the shares of stock because they think the stock could go up.
So, we looked at an example of JPMorgan about placing a covered call. We looked at the example of Boeing, where that's an example of something that was out of the money, meaning the stock price was not above that strike.
And lastly, we looked at an example of Zoom, where we said, hey, the stock has gone up a lot and is quite far above that strike price, and what could the investor consider. We said two options. If the investor is OK with maximum gain, the investor had to do nothing. Just let the stock close above the strike. If the investor decided, no, I want to keep the shares, the investor does have the option, keyword, prior to expiration, to buy that call back. If the call has appreciated in value, that tells you the stock has also gone up as well, OK?
So very important to remember those things, whether the option is out of the money or the option is in the money.
And there you have it. Those are the basics you need to trade your first covered call. The next step is to download the thinkorswim paperMoney platform to start practicing.
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