COVERED CALLS EXPLAINED

I have a new series on TikTok where I am going to sell a covered call against my HIMS stock every single week (unless my shares get called away, in which case I will sell a cash secured put instead, but we’ll get to that later). In doing so, I’m going to generate roughly $180 a week in premium.

WHAT IS THE PREMIUM?

On the other side of my trade is a person, an institution, a market maker, who wants my shares. We are making an arrangement.

I purchased 100 shares of HIMS at $56. I sold a covered call with a strike price of $58. He pays me a premium (which will fluctuate weekly based on the volatility of the stock) to essentially say, Hold those shares for me, because if they’re over 58, I get to buy them from you AT $58. He is paying for the right to buy the shares at the strike price.

Now, say by Friday (I sell weekly calls, but you can do nearly any time frame you imagine. I like weekly because it gives me weekly income and the premiums can be higher), the stock is $62. My shares are assigned, which means they’re gone. They get sold to the person on the other side of this “bet.” Except he buys them at $58 per share.

This means a few things to me: One, I will realize a profit on the shares being assigned. Since I have 100 shares and I bought at $56 and they were assigned (or sold) at $58, I make $2 per share, or $200. I also make whatever the premium was, which as of this writing averages $180 a week.

That means I walk with $380 in profit (minus taxes).

But the other person gets my shares at $58 and the stock is now $61, which gives them a profit of $300 (minus the $180 they paid me for the premium).

STRIKE PRICE

But what if the stock does NOT hit $58 or above? Then, I keep the premium, which means the person on the other side lost our “bet.” I also get to keep my shares. You can pick whatever strike price you want, but the strike prices CLOSEST to the current stock will pay a much higher premium, because it’s riskier for you, the owner of the 100 shares - there’s a higher chance your shares will be assigned.

So, you make more money from the premium, but run a higher risk of assignment. The further out you go, the safer it is in regards to assignment.

Think of it like this: If I bought the stock at $56 and sold a covered call with a strike price of $57, it would be VERY likely that in one week, the stock could hit $57 and I’d lose my shares. Because of this, I demand a higher premium to make it worth my while.

If I go to, say, $63, the premium will be MUCH less with a weekly expiration because it isn’t very likely that the stock will go up 12.5% in one week. Not impossible. Just unlikely. And because of this, the premium will be much less.

Take a look. To the Far right you see “STRIKE.” You also see that the stock is $58.19. So if I sell a contract just slightly out of the money ($59), the premium is $1.51 or $151 per contract. It’s much more likely it’ll go from $58.19 to $59 in a week. But what if I pick a 65 strike price? The premium is only .28 or $28. You make less because there’s less risk.

ROLL THE OPTION

Now say it’s Friday and the stock is $58.85 and the strike price is $59, but I bought the 100 shares at $56. It is VERY likely that the stock will close over $59 and I’ll lose those shares.

Since I purchased it at $56, I’m not terribly worried about my shares being called away. If they’re assigned, I’ll just purchase the shares back the following Monday (or I’ll sell a cash secured put - but again: more on that later). I’ll make a small profit, I’ll keep the premium.

But … what if I bought the stock a long time ago when the stock was $10 per share. And I REALLY don’t want to lose those shares?

Why wouldn’t I want to lose them?

I could owe a big tax bill (If I bought at $56 and was assigned at $58/59 I’d owe taxes too, but MUCH less).

I lose my very low cost basis, which I might not want to lose. I might be more cautious in buying 100 shares now that the stock is in the mid-50s.

Here, I would have a few options:

1. I could BUY BACK the contract by closing it before expiration. You just go to your brokerage, hit the little down triangle and hit “close positions” or “roll positions.”

2. If I’m closing the covered call and I have a loss, it might cost me a LOT of money to buy back the options contract. BUT in doing so, I keep my shares. If doing this is too risky for me and I decide, I don’t want to sell covered calls on something that I ideally want to hold for a long time, I might just close the position and not sell covered calls anymore.

3. If I want to sell another covered call next week, I might opt to roll the position. Rolling the position means I buy back the call (so I take a loss), and I simultaneously sell a NEW call for the following week or whatever date/strike I choose. This allows me to also keep my shares.

The downside is that I might pay more to close the position than I will make on the next week's premium and I am exposed to new risks. Say the volatility cools off next week and the premium isn’t worth very much. BUT! I get to keep my shares.

So, in summary: If I buy the stock at $56 and sell a strike for $58, I’m not going to bother rolling anything. I’ll just take the profit on the sale of the stock and the premium and I’ll buy it back next week.

But if I bought the stock at $10 and it’s $56 now and I don’t want to lose my low cost basis/I want to avoid a big tax bill, then I will consider buying back the option or rolling it if I still want to make the covered call premiums.

One other thing to note: The cost of rolling your option (taking a loss) CAN exceed what you’d make in premium, so it isn’t always profitable, but it is an option you can use if you want to keep your shares.

ASSIGN BY LOT

Now, let’s say you’ve been investing in this company for a while. You have 100 shares at $10 and 100 shares at $56, which you’ve purchased expressly for the sake of selling covered calls. You do not want to lose your $10 purchase price - that’s your long term investment. It’s for the future.

But if the position at $56 is called away, who cares?

Thing is: How do you convey this to your brokerage. How do THEY know which sales to assign if they’re called away?

You have to specify your cost basis method. Here’s how you do it on Schwab, which is the only brokerage I’ve ever used. So if your question is: how do I do this on Robinhood/Fidelity/eTrade, etc.: I have no idea. Call them and ask.

But on Schwab, you click on the profile tab:

Then you click on the COST BASIS METHOD:

And once there, you’ll see this:

Now the position you bought at $10 was your first investment years ago. So, the default method is FIFO: First in First Out. But you don’t want that, right? You want to hold onto the shares you bought at $10. So you go here and you hit LIFO: Last in First Out. That means when your shares eventually DO get assigned, your brokerage knows to sell the position you bought most recently: the shares at $56.

NOTE: Some brokerages might allow you to assign your shares during the transaction or retroactively. Schwab doesn’t, which is why I have to set it up this way.

CASH SECURED PUT

Ok so now let’s say you buy an entirely new position strictly to sell covered calls. You buy 100 shares at $56. You sell a covered call with a $58 strike price. The stock price rockets to $64 (or simply just lands exactly on your strike of $58.00) on the day they expire. Your shares are assigned.

You keep the premium AND you keep the profit from 56-58. You unfortunately miss out on the profit to $64 or whatever. But that’s the game.

Now you want to do this all over again. But you can actually make money selling a cash secured put, too. The put is a bet that the price will go DOWN (and like the calls, they can expire weekly or on any time frame). Here, too, you earn a premium. And the “cash secured” part means you have the money to buy the shares if the stock does drop to the price you thought it’d drop to.

So, say the stock rockets to $64. Your shares are assigned. You say, okay, there’s no way this stock will drop to $56 again, at least not next week. But it COULD drop to $60 if people step in to take profits.

You also happen to have $6000 (the cash is secured - you have the money ready). So, you sell a cash secured put with a $60 strike price.

Now you’re making the bet: I bet this stock will be 60 next week and if it hits $60, I’ll buy it.

The person on the other side is paying ME a premium because he’s saying, no matter what, if it’s $60 or below, YOU HAVE TO BUY IT AT $60.

So, say the company has some terrible news and the stock drops to $51. I am obligated to buy it at $60.

If the stock closes at $60.01 or anything above $60, I am not obligated to buy the shares anymore AND I get to keep my premium.

Of course, there are huge risks involved with this strategy, too. I might have to buy the stock at $60 even if it’s $51. Buuuut, I get a premium. So I might roll the dice and say, Well: I don’t THINK anything bad will happen this week, and I’d rather make some money. I’m basically being paid to wait and buy the stock at the price I want to pay.

Now, I might say, Hmm. Earnings are coming out next week. And I just don’t know. The economy is fragile/that sector is risky/the competitor had bad earnings last month … I might say, skip the premium, it’s not worth the risk. I’ll just sit on the sidelines and wait and see what happens next week. Then I’ll buy back the 100 shares whenever I’m ready and sell covered calls.

However, this strategy is called the wheel. You:

Buy 100 shares.

Sell a covered call.

The shares are maybe assigned, you make the profit + premium.

You sell a cash secured put.

You make the premium + you might get the shares back at the lower price you wanted

You have 100 shares again, so you …

Sell a covered call.

You do this over and over again and it is a wheel.

To sell a Cash Secured Put you need to remember: If assigned, you’re on the hook to buy 100 shares, which means you need that cash sitting in the account. It is the exact opposite of selling a covered call.

You go to the options chain, and under the PUT side, you hit “BID” on whatever strike price you want, then drop the pulldown tab to 1 since you’re selling one cash secured put, and then confirm your order.

You can ignore “MAX LOSS” - that’s just the computer reminding you the max loss would be 100% if the stock went to zero.

So in this case, the stock is currently $59 and I’m selling a Cash Secured Put at $58, which means if it drops to $58 by expiration, I’m on the hook to spend $5800, but I will also earn $117 in premium to do something I was going to do anyway: buy the stock if it drops to $58.

OTHER THINGS TO CONSIDER:

You can buy back the option before expiration if you’re happy with your profit and worried that some good news could come out and pump up the market. Say you sell a covered call with a $57 strike and it’s $54 currently and you’re showing a profit. It might not be the full amount of your covered call premium, but it might be close … and you might say, hey, this is close enough. You could buy back the contract on any day you wanted and lock in a gain, albiet a smaller one

Early Assignment

One of the rare cases where shares might be assigned before expiration is when the company you’ve sold a covered call on pays a dividend. For example: you sell a call on Monday that expires Friday, but there’s a dividend coming on Thursday and the ex-dividend date is Wednesday. The option buyer might choose to exercise on Tuesday, so they’re holding the shares in time to collect the dividend.

In that case, your shares get called away early. You don’t get the dividend, but you do keep the premium. It doesn’t happen often, but it’s something to watch for — especially if your option is already in the money and the dividend is juicy enough to be worth the early exercise.