Mastering The Covered Call Final

Letter from Kirk
Covered calls are the proverbial “bridge” which many traditional stock
investors cross into the world of options trading. The gateway or door
to a new paradigm of investing that, when used correctly, offers higher
returns and less risk. Yet, most investors are scared away before they
even take the first step.
We are taught by traditional media, schooling, and decades of

conditioning that the only way to invest and build wealth is via stocks.
That you cannot beat the market so why try? But, what if that wasn’t
actually true? Wouldn’t you have a moral obligation to change the way
you invest if we proved that you could beat the market? We think so.
The goal of is this book is to help educate you on how options trading,
in particular covered calls, can help transform the way you build wealth
and invest your hard-earned money. You see, options trading isn’t new;
it just might be new to you. All you need is someone to hold your hand
and help you walk across the bridge.
There’s a completely new world waiting for you and I’d love to be your
guide as you start, or continue, this journey. Let’s get started…
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Table of Contents
1) Options Basics 5
2) Covered Calls 20
3) Strategy Setup 29
4) Position Management 43
5) Synthetic Strategies 52
Chapter One
Options Basics
buyer. Typically, one option contract controls or
leverages 100 shares of the underlying stock. Option
Whether you're an experienced options contracts include four additional elements; an
trader or a newbie, it's easy to jump into expiration date, strike price, option premiums, and are
classified as either calls or puts.
this guide with both feet and dig right into
the covered call strategy. NOTE: We'll often refer to the stock shares as the
underlying stock or underlying shares. The term
If you're the latter, let's first make sure you have a little "underlying" is specific to the world of options trading.
background info on options trading jargon, or you It references the stock shares that serve as the base,
might quickly get confused. As such, we thought it or basis, for the options contract, which is created on
would be good to go over a bunch of essential top of the shares. Since options contracts derive their
"options basics" together, including options specific value from the stock shares, we use the word
terminology. If you're already an experienced investor "underlying" to describe the logical hierarchy of the
and familiar with options, feel free to skip right ahead option contract. The option contract is built on top of
to Chapter 2. If not, then you'll enjoy the newfound the stock; therefore, the stock shares are underlying to
jargon, which is unique to options trading. the option contract.
In either case, it's always good to go through the Expiration Date
basics and make sure you understand the foundational
elements before moving forward. So, try not to skip Options expiration is the date when the option
this section. Please take the time now to develop, or contract for the underlying stock expires or is
refresh, your basic options trading knowledge. terminated. It's the point at which the option buyer
ultimately has to decide to convert, or what is
Options Contract commonly referred to as "exercise," their option
contract into shares of stock. Most optionable stocks
An options contract is simply an agreement between
have a wide variety of expiration dates. These include
two parties for the sale or purchase of an underlying
weekly expirations, monthly expirations, and quarterly
stock at a pre-determined price in the future. Each
expirations.
option trade requires an option seller and an option
Chapter One Option Alpha © 2019. All Rights Reserved. 6 of 65

For example, you might enter into a contract that Option Premiums
expires in 30 days or 90 days from today. As the name
As you might expect, there's no free lunch when
suggests, the expiration date for options contracts can
trading options and all option contracts require a
vary in the future so that both option buyers and
sellers can appropriately match their desired timeline premium to be paid by the option buyer to the option
seller to complete the transaction. The buyer always
and exposure. As a general rule, the further out in time
pays the premium, and the seller always receives it no
the expiration date is, the more valuable the option
matter what type of option you are trading, whether
contract compared to a shorter expiration date
call options or put options, which are discussed next.
contracts.
Option prices are quoted in dollars per share for
Strike Price simplicity, but more often, this creates a little
confusion for traders.
In any option contract, the two parties (option buyer
and the option seller) need to agree on the price at For example, you might see an option contract price
which they are mutually comfortable, either buying or quoted as $1.45 on your broker platform. This means
selling stock in the future. This future price is called that the contract's value is $1.45 for each share, and
the strike price. It is called this because it is the price since the standard contract multiplier is for one
at which they "strike a deal" on agreeing to exchange contract is to leverage or control 100 shares, the
underlying shares regardless of the market value of actual real value of the contract in total dollars is $145.
the shares at the time of expiration. The strike price Likewise, an option contract quoted at $0.37 is worth
can vary greatly and range in prices below or above $37 total dollars and an option contract quoted at
the current underlying stock price. $4.78 is worth $478 total dollars. Option premiums
change frequently and are determined by two main
For example, let's assume that shares of stock for a factors; intrinsic value and extrinsic value, which we'll
company are trading at $95 per share. You could trade cover in more detail in an upcoming section.
an option contract with a strike price of $105,
effectively $10 above the current market price, or with Call & Put Options
a strike price of $80, effectively $15 below the current
There are only two classifications, or types, of options
market price. Strikes prices can have increments as
contracts; call options and put options. Since you can
low as $0.50 to as wide as $50.

choose to be either an option buyer or seller of calls Exercise & Assignment
and puts, we want to first walk through the rights and
Now that we've covered the four main elements of an
obligations of each scenario. As a general rule, buyers
options contract lets quickly discuss the logistics of
of options have rights, and sellers have obligations.
Keep this quick rule in mind as we move forward. how exercise and assignment work. Exercise and
assignment are the processes by which options
Call options give the option buyer the right, but not contracts are converted to underlying shares. Oddly
the obligation, to purchase the stock at the strike price enough, it's effectively the same transaction
at expiration. And because the choice to buy stock, or happening but commonly called two different names
not, in the future is valuable, call option buyers pay an depending on which side of the contract you are on
option premium in exchange for this right to choose. initially; buyer or seller.
Alternatively, the premium paid by the option buyer
As a reminder from a couple paragraphs back, option
goes to the call option seller, which now has an
buyers have the right, but not the obligation, to
obligation to sell the stock at the strike price at
exercise (convert) the option contract into underlying
expiration, or before, if the option buyer exercises or
enforces their contract. stock. Therefore, the option buyer is always the one
who could exercise their contract, and the option
Put options give the option buyer the right, but not seller is always the one who gets assigned an options
the obligation, to sell the stock at the strike price at contract. It's as simple as that. Buyers exercise, sellers
expiration. Just like call options, this choice to sell the are assigned.
stock, or not, in the future is valuable. Therefore, put
option buyers pay an option premium in exchange for The question you should be asking at this point is,
"When would an option buyer exercise their contract?"
this right to choose. The premium paid by the option
The option buyer would only choose to exercise their
buyer goes to the put option seller, which now has an
contract and buy/sell shares at the strike price if it's
obligation to buy the stock at the strike price at
financially profitable for them to do so before or at
expiration, or before, if the option buyer exercises or
enforces their contract. expiration. Again, pretty simple when you think about
it logically.

If exercising their contract would create a larger loss As a call option buyer, you now have the right, but not
than the value of the option premium paid to enter the obligation to purchase the stock for $57 per share
into the agreement, then the option buyer would anytime in the next 60 days. After 60 days, your
simply let their contract expire worthless. In this case, contract expires, and you no longer have this right.
the option seller would keep the entire premium The call option seller, on the other side of the trade
collected at the beginning of the transaction as a from you, has an obligation to sell shares to you at $57
profit. if you choose to exercise your contract. Let's walk
through a couple of different expiration scenarios
Option Contract Examples together. Remember that as the option buyer, you’re in
control of the choice to exercise the contract or not.
Alright, we've hit you over the head with enough
terminology and definitions for now. If things are Call Scenario 1: Stock closes @ $43 per share
getting a little fuzzy and blurred, we're going to bring
all of these concepts together with a few examples. In At expiration, it seems the stock moved lower from
each example, we'll highlight the option contract $50 to $43. In this scenario, the best decision would
details and walk through the specifics of what might be not to exercise your call option contract. Why?
happen at expiration for different stock price Well, some simple math analysis shows that it would
scenarios. Let’s dive in. be financially unwise to do so.
Example #1: Call Option If you were to exercise your call option, you would
purchase the stock at $57 per share (strike price)
Here's the setup for this option contract: when it's only worth $43 per share in the open market.
Not a smart investment, so your best choice is to
1. Underlying stock is trading at $50 per share.
simply let the option contract expire and lose the $3
2. You purchase a call option contract. premium you paid to the option seller. Losing $3 is
better than losing $17 per share, the $3 premium paid
3. The expiration date is 60 days from today.
to the option seller plus the negative value of $14 from
4. The strike price for your option contract is $57. potentially buying shares at $57 when they are only
worth $43.
5. You pay an option premium of $3.

It should be noticeable at this point that call option With the stock trading at $57, there's no financial
buyers want the stock to rise significantly in value in benefit to exercising the contract as you could just as
the future. But how far does the stock need to rise to easily purchase shares in the open market for the
make it worth it for the call option buyer to convert same price. Therefore, your best decision is again just
the option and exercise the contract? Let's look at to let the call option expire worthless. The option
another scenario. seller would still keep the entire $3 premium as profit
at expiration.
Call Scenario 2: Stock closes @ $57 per share
In this scenario, we've learned a vital new piece of
The stock rose dramatically in value, and right to your information. That the actual expected price for the
strike price of $57, which is what you might have stock or break-even point, to make it profitable overall
expected as a call option buyer. Kudos to you for for the call option buyer, needs to be at a price per
picking the right direction. But, unfortunately, the share that is above the strike price plus the value of
stock didn't move far enough as you would also not the option premium paid.
exercise your call option contract in this scenario and
simply let it expire worthless. "But wait, Kirk, the stock Call Scenario 3: Stock closes @ $65 per share
moved exactly where I wanted right?" Yes and no.
Congratulations, the stock made a huge move, much
Recall that you paid an option premium of $3 to the higher and well above your call option break-even
call option seller to enter into this option trade. This point of $60 we just calculated in the last scenario. At
option premium is a cost of doing business and cannot expiration, the best decision would now be to exercise
be swept under the rug. We need to account for it your call option contact. As always, the math works, or
somewhere. So, what we do in a call option scenario is it doesn't, and in this scenario, it is financially
add the option premium to the strike price of the profitable to exercise your call option.
contract to get your effective “all-in-cost" of stock
Even after paying the $3 premium to the call option
ownership. In our working example, this break-even or
seller 60 days ago and purchasing the stock at the
“all-in-cost" is $60 per share; the $57 strike price plus
$3 option premium paid. strike price of $57, you could sell the shares
immediately in the open market for $65 per share
resulting in a $5 profit per share overall. The call

option seller, in this case, would be obligated to your contract expires, and you no longer have this
purchase shares in the open market for $65, if they right. The put option seller has an obligation to buy
didn't own them already, and sell them back to you at shares from you at $45 if you choose to exercise your
$57 (strike price) for an $8 net loss per share on the contract.
stock. Don’t forget however, they collected an upfront
But why would you want to sell the stock when you
premium of $3 from you, the option buyer, which
don't even own it in the first place? What financial
reduces their overall net loss to just $5 per share.
benefit is there in this type of trade for you? The
As you might expect having coming this far in the concept seems counterintuitive, but it's not. You see,
scenarios, purchasing call options requires both a most investors are used to a single avenue for
significant move in the underlying stock and in the generating profits. They buy the stock at a low price
right direction to be profitable. Both of which are hard and look to sell back the stock later on at a higher
to predict or estimate consistently for the option price. Buy low, sell high.
buyer. What about put options though?
Few investors realize, however, that you can use these
Example #2: Put Option same buy and sell orders just in reverse to profit from
a stock moving lower. When you reverse the order of
Here's the setup for this option contract: buying and selling, its called "shorting a stock," and
1. Underlying stock is trading at $50 per share. you profit from a decline in the underlying share price.
Sell high, buy low.
2. You purchase a put option contract.
It works like this. You borrow stock from your broker
3. The expiration date is 30 days from today. to sell to someone else in the open market. You're
betting on the stock moving lower and hope to
4. The strike price for your option contract is $45. purchase shares at a lower price later on to fulfill the
5. You pay an option premium to the seller of $2. trading loop and deliver the shares back to the broker
that you borrowed. When you do this successfully,
As a put option buyer this time, you now have the your profit is the difference between where you sold
right, but not the obligation to sell the stock for $45 shares and where you purchased shares.
per share anytime in the next 30 days. After 30 days,

Put Scenario 1: Stock closes @ $52 per share Put Scenario 2: Stock closes @ $45 per share
The stock went up before expiration, but now that you The stock fell in value, as you might have expected,
are a put option buyer, this is terrible news for you. At but still not far enough to reach your break-even point.
expiration you would choose not to exercise your put At $45, there is no financial benefit exercising your put
option contract. Why? Well, if you were to exercise option contract with the option seller. You could just
your put option, you would sell shares of stock at $45, as quickly buy shares at $45 in the open market and
the strike price, but would have to buy shares at the sell them back to the put option seller for $45, which
prevailing market price of $52 to complete the trading is essentially a wash.
loop.
Recall that you also paid an option premium of $2 to
If in this scenario, we are selling shares at $45 and the put option seller. When we subtract this from the
being forced to buy them in the open market at $52, strike price, your effective break-even target for the
it's not a smart investment decision. Your best choice stock is $43, the $45 strike price minus $2 option
is to simply let the put option contract expire and lose premium paid. So, the best choice again is to let the
the $2 premium you paid to the option seller. Losing put option expire worthless and lose the entire $2
$2 is better than losing $9, the $2 premium paid to the premium paid to the put option seller.
option seller plus the negative value of $7 from
For put options, we've now learned that in order for
potentially buying shares at $52, and selling them for
you to make money as an option buyer, you need the
$45.
stock to trade low enough so that selling the stock at
Notice how these put options are starting to behave $45 creates a net profit after paying the option
just like the call option scenarios, only in reverse? Put premium. This expected price for the stock or break-
option buyers want the stock to fall in value in the even point is calculated as the strike price minus the
future, similar to the expectations of someone value of the option premium paid, $43 in our example.
shorting the stock. I'm sure you can see where this is
Put Scenario 3: Stock closes @ $40 per share
going based on the prior option examples, but let's
walk through some more scenarios just in case it's not The stock closed well below your put option break-
100% clear. even point of $43. Things are not looking good for the

stock, and it's falling hard, but as a put option buyer, are rare. The reality is that most options contracts are
this is excellent news for you. At expiration, you would closed well before expiration by merely reversing the
choose to exercise your put option. Even after paying initial trade. Doing so doesn't impact the outcomes or
the $2 premium to the put option seller and change the decisions you make, but rather opens up
purchasing stock in the open market for $40, you the possibility to exit or adjust positions before
could sell the shares immediately back to the put expiration if you deem necessary.
option seller at the strike price of $45 per share
For example, let's assume you purchased an options
resulting in a $3 profit per share overall.
contract, call or put, with 30 days until expiration. You
The put option seller, in this scenario, would be don't have to hold it until expiration unless you choose
obligated to buy shares at the strike price of $45 from to do so. You could choose to quickly reverse your
you, when they are valued in the open market at $40 trade and sell the contract to someone else, which
per share for a net loss on the shares of $5 per share. closes your position. Likewise, if you sold an option
However, they collected an upfront premium of $2 contract to an option buyer, again call or put, you
from you, the option buyer, which reduces their overall could buy back the contract from someone else and
net loss to just $3. close the position, thereby removing your obligation
to deal with the stock at expiration.
As we witnessed with the first call option example,
purchasing put options requires both a significant Statistically speaking, at Option Alpha we've only ever
move in the underlying stock and the right direction. had to deal with the assignment of physical stock less
It's tough to predict or estimate consistently how far a than 1% of the time in the last 10+ years of trading
stock will drop and in what timeframe. There has to be options. It's something manageable and won't ever
a better way right? There is, and we'll get there soon. harm you so long as you are controlling your position
size. We will explore this topic in more detail during a
Reversing Trades later chapter, but be aware that it is not an automatic
We've talked a lot so far about buying and selling assumption of exercise and assignment, and people
worry about it way more than is necessary.
shares at expiration with options contracts. However,
you should understand that exercise and assignment In the end, we hope that the examples we just went
of physical shares, as described in the pages above, through added a lot more clarity to the relationship

between option buyers and sellers and how or when market for $100. Likewise, a call option with a strike
options contracts could increase or lose value at price of $95 would have $5 of intrinsic value.
expiration. In the next sections, we'll dig much deeper
On the put option side, the concept is the same, just in
into the factors and inputs on how option premiums
derive their value. The goal is for you to understand reverse. A put option with a strike price of $101 would
have $1 of intrinsic value as the put buyer could sell
how different market environments or situations
shares at $101 and repurchase them in the open
impact an option contract's premium or price.
market for $100. Likewise, a put option with a strike
Intrinsic Value price of $105 would have $5 of intrinsic value. Simple
enough, right? Great!
Earlier in the description of option premiums, we
mentioned that there are two main factors by which Now, any strike price that is out-of-the-money (OTM),
we determine an option's value. These are broadly on the other hand, would never have intrinsic value.
categorized as intrinsic value and extrinsic value. We'll Exercising the option contact when OTM would offer
cover each of these in detail in the following section. no immediate value to the option buyer. Call options
are said to be OTM when the strike price is above the
Intrinsic value is the current and immediate value of current stock price. Put options are said to be OTM
the option contract for any strike price, which is when the strike price is below the current stock price.
currently in-the-money (ITM). Said another way; it's
the value or profit should the option buyer exercise For example, using the same stock currently trading at
their contract immediately. Call options are said to be $100 per share from above, a call option with a strike
ITM when the strike price is below the current stock price of $101 would be considered OTM and have no
price. Put options are said to be ITM when the strike intrinsic value. The option buyer would never willingly
price is above the current stock price. choose to purchase shares at a $101 strike price when
they could easily buy shares in the open market for
For example, if a stock is currently trading at $100 per $100 per share. Likewise, on the put side, if a put
share, a call option with a strike price of $99 would option buyer owned an OTM contract with a strike
have $1 of intrinsic value. If the call option were price of $99, they would never willingly choose to sell
exercised right away, the option buyer would be able shares at $99 when they would quickly sell shares in
to purchase shares at $99 and sell them in the open the open market for $100 per share.

It should be clear by now that the intrinsic value question, its best first to strip out the intrinsic value
portion of an option contract's premium is relatively which is the easiest to calculate. The remaining
easy to calculate and understand. The second part of portion is then merely the extrinsic value. The intrinsic
an option contract's premium, extrinsic value, is a little value of the contract in our example would be $5, as
more complicated. Yet, it's one of the most important this is the value of the ITM contract if the contract was
aspects of option pricing you need to understand. exercised today. The extrinsic value would be the
remaining $1.50 ($6.50 minus the intrinsic value of
Extrinsic Value $5), which is attributed to the value of time and
There's no easy way to dissect this pricing component, volatility over the next 30 days.
so we'll just tackle this head-on. Extrinsic value Now, take the same stock currently trading at $105 per
represents the future time value of the contract based share, and let's now look at a put option contract with
on the days remaining from now until expiration and a strike price of $93 and expiration date 60 days from
the implied, or expected, volatility in the stock. We'll now, which is quoting a price of $0.60 per contract.
cover each one of these time and volatility Little harder right? Not really if you slowly walk
components individually in the paragraphs below. For through it. Here the put option contract has no
now, however, let's review a high-level options pricing intrinsic value as the $93 strike price is OTM, and the
example to reinforce the general concepts of intrinsic put option buyer wouldn't profit from exercising their
vs. extrinsic value components. contract. If no value is associated with intrinsic value,
Let's assume that our same stock from before is still then the remaining amount is purely comprised of
extrinsic value attributed to the time and volatility
currently trading at $105 per share. A call option
contract with a strike price of $100 and expiration until expiration.
date 30 days from now is quoting an option premium In the next section, we'll unpack the time and volatility
of $6.50 per contract. Can you figure out how much of components of extrinsic value as we continue to dive
the value is associated with intrinsic value vs. extrinsic deeper into what impacts an option's price. Then, we'll
value? Take your time and think about it for a minute. walk through the Option Greeks, which help us
Recall that an option's price is comprised of both understand how an option's price might change based
intrinsic and extrinsic value. So to answer our on various market forces.

Time Decay Time decay of an option contract speeds up so quickly
that at expiration, all that is left of the contract's value
The first sub-component of extrinsic value for an is simply the intrinsic value, if any. This is why time
options contract is time decay. All options contracts decay is so crucial for options traders because it
have a finite time until expiration, which can be a few creates a constant battle between time and price. If
weeks or up to a few years from the current date. You the underlying stock price fails to move far enough or
will often hear traders talking about 30, 60, or 90 days fast enough, then the option contract slowly decays
to expiration, and this refers to the amount of time under the weight of time decay.
before the contract expires.
Implied Volatility
As option contracts, both calls and puts, move nearer
to their expiration date, there is less time for them to The second and most important sub-component of an
move into a profitable zone before they potentially option contract's extrinsic value is implied volatility.
expire worthless. Hence, all contracts slowly see their Admittedly, implied volatility is the edge by which
extrinsic value erode through the passage of time as option sellers, and covered call writers, as you'll learn,
they draw closer to expiration. This erosion in value is gain a significant advantage in the market trading.
called time decay. Implied volatility is the future expectation of how far a
stock will move up or down by expiration. Since
Time decay for option contracts moves at a options have expiration dates in the future and strike
progressively faster pace as a contract nears its prices higher or lower than the current market price
expiration date. Option contracts further from for the underlying shares, it's critical that an option's
expiration will be worth more money, all things being premium factor in the magnitude expectation of the
equal, compared to contracts closer to their expiration stock's price moving forward into the future. In the
date. These further out contracts will experience most basic terms, if implied volatility is high, the stock
minimal impact on their price each day due to the is expected to swing wildly in the future. If implied
erosion of time decay. The nearer the contract gets to volatility is low, the stock is expected to swing very
the expiration date, the larger and more significant the little and mostly stay range-bound or move sideways.
impact time decay will have on the contract.
Generally speaking, implied volatility impacts the
premium of options contracts the same for both calls

and puts. When implied volatility increases, or more So, what if the expectations for future stock volatility
simply the expectation of future stock volatility change? What if implied volatility goes up to 12% from
increases, it causes an increase in the value of both 10%? Whatever the catalyst, market participants
calls and puts. When implied volatility decreases, or expect the stock to be more volatile in the future. And
the expectation of future stock volatility decreases, it as a result, start more aggressively purchasing call
causes the value of both calls and puts to go down. options at higher prices. The call option contract
might then adjust up in value from $6.50 to $7.50 per
Using the same example we've referenced throughout, contract. Notice that the only change here is the
let's assume a stock is currently trading for $100 per future expectation of volatility. The underlying stock
share. A $105 strike call option is quoted at $6.50 per price nor the time until expiration was changed, so
contract. We might also see on the option pricing you can see just how much of an impact implied
table that the stock is showing 10% implied volatility. volatility has on option pricing as a single component.
This means market participants expect the stock to
move up or down 10% between now and expiration. Option buyers might be willing to pay more money for
This doesn't mean it can't move more or less; it the options contract if they think a more significant
obviously could. It just means that the expectation move is coming in the future. Whether that move
right now, based on all information available and the comes or not is another discussion altogether, which
actions of market participants, is that the stock is we'll cover later on. The key concept, for now, is that
expected to trade somewhere in a 10% range up or traders and investors bid up and down an option's
down. price in relation to how far they believe or expect a
stock to move in the future.
“Kirk, who comes up with this number?” Funny you
should ask because you do! Well, not you in particular, Keep in mind that the quoted implied volatility
but market participants and investors, just like you number could be different for each stock or ETF.
determine this number due to how aggressively or not, Some stocks might naturally experience more volatility
they purchase call and put options. This is why it's compared to others. An implied volatility reading of
referred to as implied volatility because the value is 35% on Facebook could be a reasonably low reading
"implied" by the actions of the market participants as for such a large tech company. In contrast, an implied
a whole. volatility reading of 35% for Exxon Mobile might be

very high for a large, stable oil and gas company. It's the value of call options and decrease the value of put
all relative, so we use implied volatility ranking to options, all else remaining constant. Delta values can
normalize the stocks and ETFs we monitor. also be used as a proxy for an option contract's
reaction to directional price changes in the underlying
Option Greeks stock shares.
When setting up and monitoring positions, traders 2) Gamma
often use or discuss option greeks. There are four
main greeks, including Delta, Gamma, Vega, and Gamma is the rate of change in an option's Delta per
Theta. A common misconception is that the greeks 1-point move in the underlying stock's price. You can
predict the future movement and value of an option think of Gamma as an important measure of the
contract. It is not true. They are not predictive but convexity or rate of change of an option contract's
rather are simply elements that reflect what "could" value in relation to the underlying continuing to move
happen in pricing changes for different market either further in one direction or closer to expiration.
situations. Below, I'll briefly cover each one as we'll use Gamma risk, or the risk of large price movements in
some of these greeks in subsequent chapters for the option contract, increases as you near expiration.
covered calls.
3) Vega
1) Delta
The option's Vega is a measure of the impact of
Delta measures the extent to which an option contract changes in the implied volatility on the price of the
is exposed to changes in the price of the underlying option contract. Specifically, the Vega of an option
stock. Delta values can range from 1 to –1 depending expresses the theoretical change in the price of the
on the option contract you are trading and represent option for every 1% change in underlying implied
the theoretical change in an option's price following a volatility. Keep in mind, as we discussed earlier, small
$1 increase in the underlying stock price. changes in implied volatility could have significant
impacts on an option's price, particularly option
Deltas are always positive for call options and always contracts further from their expiration date.
negative for put options. This is because a $1 increase
in the underlying stock price should always increase

4) Theta
The last major greek is Theta. Theta is the decay of an

option's price due to time. Theta values are always
negative for both call and put options and will always
result in zero-time value at expiration. Often, traders
refer to it as the "slow drip" or "silent killer" of option
buyers since it slowly erodes positions.
As expiration approaches, Theta speeds up, and the

rate of decay of the option contract accelerates as it
runs out of time. For option buyers, Theta can be
death by a thousand cuts. On the other hand, option
sellers consider Theta decay an important component
for many income-based options strategies.
Conclusion
Alright - Whew! That was a lot of basics to cover, and

hopefully, you didn't skim through this chapter as
there are some golden nuggets in there you won't
often find in other 'Options Basics' write-ups online.
Now that we have got these covered, no pun intended,
it's time to shift our attention to the options strategy
so very few stock traders take advantage of, the
covered call.

Chapter Two
Covered Calls
ETF shares in your account before selling the call
option. Because you are selling a call option, this
When introducing covered calls to new means you have the obligation, if assigned by the
traders, we're presented with a challenge: option buyer, to deliver shares of stock at the strike
price on or before expiration. It's referred to as a
cover the step-by-step details on how to
covered call because when you sell the call option, the
set it up or the overall framework on "why" risk of assignment is already "covered" given that the
we use them before diving deeper. underlying shares are in your possession. Contrast this
with a "naked" call option in which case you have no
While there's certainly no right or wrong way to go
underlying shares to cover the risk of assignment and
about it, we feel that first covering the overall
would have to come up with the money if the stock
framework of a covered call seems best to set the went against you to cover a loss.
stage for our discussion. Don't worry if it sounds
complicated at first, we will be talking in more detail NOTE: Naked call selling is nothing bad at all as it
about exactly how to set up a covered call and how it requires much less capital than a traditional covered
works later on in the book. The goal here is just a call, mainly because you don't have to purchase the
quick snapshot and overview of what a covered call is shares of stock first. We don't want you to write it off,
broadly as a means to help build a more solid no pun intended, as it's one of the core foundational
foundation moving forward. elements of many other option strategies that don't
involve stock.
What Are Covered Calls?
Covered Call Payoff Diagram
A covered call is an options strategy that combines
the use of long underlying stock to cover the sale of a The covered call payoff diagram is constructed on the
short call option. Yes, you are going to be selling next page for you. The dotted blue line represents the
options contracts. No, you are not going to buy payoff line for long underlying shares of stock. The
options. green dotted line represents the payoff line for a
single short call option at a strike price near where you
Traditionally speaking, a covered call strategy would
purchased long stock. The red solid line shows the
require that you already own the underlying stock or
Chapter Two Option Alpha © 2019. All Rights Reserved. 21 of 65

combined payoff when both the long stock and short Visually, you can see this in the graph as the new
call option are combined into a covered call strategy. payoff line for the covered call strategy (red) crosses
over the break-even threshold much further to the left,
which represents lower stock prices. The stock could
Long Stock
fall in price and you could still make money overall.
Profit
Who Can Trade Covered Calls?

Covered Call
Covered calls can be traded in practically any
brokerage account type; retirement, IRA, 401k, margin,
etc. Since you already own the stock and therefore
have one part of the strategy in place, brokers allow
you to sell a call option against that stock that you
Loss
own if you choose to do so. You'll also hear this

Short Call referred to as "writing" a call option which is used
Low Stock Price High Stock Price interchangeably with "covered."
The best way to think about a covered call, in our view,

Notice that the slope of the red payoff line shifts from is as a strategy to pre-sell your current stock shares in
upward and to the right to flat and stable at the strike the future at a higher price. Sure, you could sell your
price of the short call option. At this junction, the shares and close your position now, but what if you
gains on the long stock shares are directly offset by could pre-sell shares at a higher price in the future and
the losses on the short call option contract. However, collect some income along the way should the shares
in exchange for capping your gains on the stock, your never reach that level? Sounds too good to be true?
break-even point or cost basis on the shares is It's not.
reduced by the amount of the premium collected. The
reduction in net cost to own the shares increase the By selling the short call option as part of a covered
probability of being successful with the overall call strategy, you are effectively just pre-selling your
position. shares. More specifically, you are pre-selling the right
to buy your shares to someone else. Straightforward

enough, right? The call option buyer, in this case, is to remember when setting up a covered call is that
not obliged to purchase the shares from you, they are you must already be long the underlying stock.
just buying the right to do so if they choose, and in Owning stock is known as being long the stock, and
exchange for this opportunity, they pay you an option without ownership of the stock, you can't technically
premium upfront. The price at which you feel sell a covered call.
comfortable selling the rights to your shares is the
That said, one of the significant benefits new traders
strike price of the contract. The money you collect
see with a covered call is that you don't have the
upfront from the call option buyer is the option
hassle of handling the shares during an assignment. If
premium or option price.
the call option is assigned, the broker simply takes the
Let's use a straightforward housing analogy to drive long stock shares from your account that acted as
home this concept. It would be like owning a house collateral. We will debate the merits of stock
and signing a contract for another person to buy your ownership later on in the book, but for now, we’ll
house, which you already own (stock shares) at a assume you do want to own a bunch of stock for some
predetermined price (strike price) by a specific date in reason or another.
the future (expiration date). In exchange for you
Why Should You Sell Covered Calls?
agreeing to sell them your house and taking it off the
market until expiration, they might pay you a deposit As great as stock ownership is, or isn't depending on
(premium) to compensate you in case they don't who you talk to, the question now is about the utility
come through on their end and purchase the house. of doing a covered call strategy. Why use covered calls
In this example, you are the owner of the underlying at all? If I had to boil it down into one main factor, the
main reason for using the covered call strategy would
stock (your house) and the call option seller. The new
be cost basis reduction. Said another way, by selling a
buyer you sign the contract with is the call option
short call option above where the stock is trading and
buyer. Honestly, it's not any more complicated than
receiving the option premium from the option buyer, it
that, so let's dive a little deeper into a covered call
strategy and look at how and why you would set one reduces the cost of owning the shares by the amount
of the premium.
up for your portfolio. Though we briefly mentioned it
above, I want to reiterate that a key concept you need

This reduction in cost basis via the premium collected, Can you immediately see how powerful the strategy is
moves the break-even point, or the net-cost, on your for the covered call writer, i.e., you? If the stock goes
stock ownership lower. You don’t have to be a rocket down, you've already reduced your break-even point
scientist to know then that a lower break-even point to $110 per share. You still might lose money if the
increases your probability of successfully generating stock continues to move lower, but your overall risk is
money and income. reduced because of the covered call you sold. If the
stock trades sideways in a range or anywhere below
How do you figure out the new cost basis or break- $125 (strike price), you keep the entire premium from
even point? Subtract the option premium you received the call option you sold ($5.00). If the stock rallies,
selling the short call option from the initial cost of the then you are capping your profit to just $15 per share,
shares you purchased. Do this just once on a which is the strike price of $125 less the net cost of the
calculator, or in your head, and you can quickly see shares of $110.
why selling covered calls is a profitable strategy long-
term when executed repeatedly. Many investors consider this last aspect of "capping
your returns" to be one of the downsides to selling
JPM Covered Call Example covered calls. We would remind them, however, that if
Let's practice with a simple example: you get to the point where the stock rallies beyond
your strike price, you've still made $15 per share in
• You spent $115 per share to buy 100 shares of profit in a month’s time. Are you really going to be
JPMorgan Chase (JPM) for a total cost of greedy about making money? Probably not.
$11,500.
What is so exciting to us about combining the long
• You sell a call option with a strike price of $125, stock with an option selling strategy, like a covered
which expires 30 days from today and receive a call, is that you now have multiple paths to create a
$5.00 option premium ($500 of total value) successful trade. It's almost like renting out your stock
from the option buyer. shares to someone for a set time period, i.e., until
expiration, and they pay you for the privilege of doing
• You have now reduced the cost of owning your so. And because you've reduced your cost basis on
shares to $110 per share or a new total ownership the shares, it turns what would be a 50/50 directional
cost of just $11,000.

bet on the stock into an overall strategy that has a with all the benefits of trading covered calls, there's
much higher probability of success. one significant, glaring downside risk to the strategy
that's always present; the stock itself.
Think about it for a second. Do you have a higher
probability of success owning JPM stock at $110 or It might be a hard pill to swallow for long time stock
$115 per share? Self-explanatory right. Plus, if you own investors, but the facts are what they are. Stock
shares in stocks which don't pay dividends, it's an ownership is a risky and inefficient use of capital that
excellent alternative for collecting income from often overshadows all the benefits of executing a
growth-focused companies by leveraging the power of covered call strategy. We'll discuss in a later chapter
options contracts. how you can reduce this risk using options, but for
now, we think it's important to point out that owning
Now, imagine that instead of going through this shares still means that you carry all the downside risk
process just one time, you replicate a covered call of the stock falling lower in a sell-off or crash scenario.
strategy multiple times each year, over dozens of While this doesn't happen often, it doesn't mean it
years. Oh yes! You see, we've only skimmed the won't ever happen or won't happen to you at some
surface because the example mentioned above was a point. Just be conscious of the risk.
single covered call in a single expiration month.
Imagine if you sold a covered call through the year for Do Covered Calls Beat The Market?
multiple years? The constant and relentless premiums
At this stage, it seems we've done as much theoretical
you collected would slowly chip away at your cost
setup as we need, and it's time we shift our attention
basis in the underlying stock, effectively allowing you
to invest in the stock at lower and lower prices. to some hard data on covered calls performance.
Some of you might be cynical, rightfully so, and
At this point, we know that you're getting excited and wondering how profitable covered calls were
motivated to sell your first covered call. We've been compared to the overall indexes? Or if the sub-title to
teaching this long enough to know when the light the book, "1 Hour Per Month Strategy That
bulbs start to turn on. Maybe you think you've found Outperformed The S&P 500" was just a bunch of hot
the holy grail of investing. And while we don't want to air to lure you into downloading this book?
dampen your enthusiasm, we do need to discuss the
risk involved in selling covered calls. Because even

Figure 1: Value of $1 Invested - S&P 500 Return (SPX) vs. CBOE 30 Delta Buy-Write Index Return (BXMD)
$30
$25
$20
$15
$10
$5
SPX BXMD
$0
1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018
Often in the world of investing, options trading gets options strategies to show what the result of each
bad press, or you hear that the only way to make strategy would be when traded against the S&P 500
money is through index investing, but it's just not the Index, as well as other global benchmark indexes such
case, and the data proves otherwise. So let us present as the MSCI EAFE Index. They included covered calls
the facts using third party validation. in this approach by creating the “30 Delta Buy-Write
Index," which tracks the performance of selling
Covered Call Performance vs. S&P 500 (Fig. 1) covered calls while also being long the S&P 500 index.
The ticker symbol for the index is BXMD. Each month
The Chicago Board Options Exchange (CBOE) put
together a set of benchmark indexes for different the index would sell a covered call at a 30 delta strike

price against on the S&P 500 and kept doing this excess return, or Alpha, above the market benchmark,
month after month, year after year. The CBOE tracked and with lower volatility or swings in your portfolio.
performance going back to 1986 until 2018, and these
And while this is only one of the hundreds of case
are the results.
studies that prove covered calls work, it's one of the
The S&P 500 annualized total return during the 32 more influential ones in our opinion because it was
years was 9.80%. The covered call strategy (BXMD), executed on the S&P 500. The very index that
on the other hand, witnessed an annualized return of everyone says you can't beat, and you should simply
10.20%. To put this into perspective, for every $1 buy and hold, yet underperformed a straightforward
invested, the S&P 500 returned $20.85, and the covered call strategy. The CBOE's findings show
covered call strategy returned $23.65. That's more without a doubt that options trading, when used
than a 13% outperformance! But that's not all; the correctly, can enhance your portfolio returns while
numbers and data get even better when you look at also smoothing out the volatility.
portfolio variance and volatility metrics.
NOTE: The CBOE provides the daily and monthly data
During their research over the 32 year period, the for each index and strategy for free on their website if
standard deviation, or portfolio volatility, in the S&P you want to double check the results for yourself. We
500 was found to be 14.90% with a maximum included a link to the CBOE website in the appendix to
drawdown of -50.95% at any given time. The covered this guide, as well as additional backtesting research
call strategy (BXMD) on the other hand, saw reduced we have performed here at Option Alpha that cover a
volatility at just 12.80%, with a maximum drawdown of wider array of tickers and covered call variations.
-42.73%. That. Is. Crazy.
Once you get familiar with which strike prices and
Not only did the covered call strategy outperform the expiration months to choose, you could do this in the
market by generating more money overall for the same amount of time it would take you to check your
portfolio, but it also created far lower volatility in your Facebook status or send a text message to a friend.
account. Isn't this what all investors are seeking? We said in the book sub-title that it takes an hour to
Better returns with fewer ups and downs in your implement. We lied. It probably doesn't take that long
account and more consistency? By now, it should be at all, and we are assuming you have to walk to a
abundantly clear that the covered call generated an library, uphill both ways, in the snow, use dial-up

internet, and move with all the lighting speed of a of data (beginning of 1999 to mid-2019) across 109
sloth. Instead, we honestly believe that this strategy, popular underlying ticker symbols and 5,550,676
once a month, could be set up and executed in less covered call trades. We found clear and convincing
than three minutes. evidence that covered calls work best only within the
context of a particular set of market environments.
So, do yourself and your wallet a big favor, stop
checking email or social media just one time during Spoiler alert! Though the CBOE’s 30 Delta Buy-Write
the month. Just once. Give your money, your family, Index (BXMD) did outperform the S&P 500, when we
your future three minutes of your time and execute a analyzed the performance of a 30 Delta covered call
covered call (or something even better we'll discuss entered 30 days from expiration we found it to
later on in the book) and start outperforming the perform very poor compared to other covered call
market with more consistency. It’s a no-brainer! setups. Does this mean covered calls won’t work?
Nope; they do work. It’s just that we found more
Better Covered Call Performance? attractive setting to use.
As great as all the data and numbers were in this We wrapped all the research and analysis up for you in
chapter, the next logical question you should be a beautiful report on Covered Call Performance. You
asking is, "can we do any better?" Yes actually! The can find a copy of this report, along with all the other
CBOE only gives the results of two covered call backtesting research we do at Option Alpha, on our
variations; a 30 delta short call (BXMD) and a 50 delta website. Alright, we’ve said too much already, and
at-the-money short call (BXM) both 30 days from before we go too far down this rabbit hole, let's
expiration. But there are many more strike prices and continue with covered calls for now and walk through
days until expiration for option contracts available to the details on setting them up in your trading account.
trade. How do we know that the parameters the CBOE
used for their indexes are the most profitable for you?
Well, our research team set out on a new mission and

decided it was time to analyze the popular covered
call strategy from all angles. We spent many months
of research examining approximately 20 years' worth

Chapter Three
Strategy Setup
3. Choose the Call Option Strike Price
Now that you understand the "why" behind 4. Monitor & Adjust Position As Needed
covered calls, let's talk about the actual It seems simple enough right? It is broadly speaking.
setup mechanics involved. But each step has its unique risks that could cause the
entire strategy to fall apart or at that least not perform
There are several key steps to go through when at the optimal level it could. So, let's tackle the first
setting up a covered call. In this chapter, we'll review three steps in this chapter, which will get you the point
the step-by-step process and look at a couple of at which you can place a new trade. We'll save the last
covered call examples together so that it's clear how step on monitoring and adjusting positions for the
to implement it in your account. next chapter.
You should first understand that the entire process we NOTE: Throughout this book, we refer to the
are going to cover takes seconds to execute and fill in underlying security mostly as stock ownership in a
the market. The reason we bring this up now is that in company. Most investors who transition into covered
our opinion, there is no excuse for not performing this calls do so via ownership in individual company stock.
in your brokerage account immediately after reading However, it should be noted that you can and should
this book and our performance research report sell covered calls on ETFs. So, please don't
mentioned at the end of the last chapter. Every single misunderstand our use of the word "stock" to mean
stock investor should be executing covered calls at that we only suggest initiating covered calls on
one point or another. But we digress, let's get into it, individual companies - we don't. We believe you can
shall we? and should sell covered calls on any underlying you
have an ownership in, stocks, or ETFs.
Here's the step-by-step guide we'll follow as we
progress through the chapter: Step 1: Own or Purchase Long Stock
1. Own or Purchase Long Stock With so many stocks to choose from, it can be
daunting to know where to start. And before we get
2. Select Expiration Date or Contract Month
any further, let's be clear with the following point.
Chapter Three Option Alpha © 2019. All Rights Reserved. 30 of 65

There is no single answer as to which stocks you there might not be a market for options that exist for
should or shouldn't pick to set up a covered call that security. Naturally, the first scan we can run then
strategy; it's ultimately a personal decision you have to is to filter for only the optionable stocks. Most broker
make on your own. platforms can easily do this for you in a couple of
clicks of the mouse, so let's continue moving forward.
The purpose of this section is not to tell you which
stocks to trade covered calls on, instead, offer some Once you find all optionable stocks, the next hurdle to
key decision points that might help you decide which jump over is filtering for a large and liquid options
stocks are suitable for your account and investing market. Liquid markets allow you to more easily enter
profile. We believe there are three main factors you and exit covered call positions and at better prices.
should take into account when it comes to choosing This step is crucial and requires a little more digging
your underlying stock or ETF. We'll briefly touch on and research, so take your time and get it right.
each of these areas to give you a clearer picture of
Liquidity is a fluid thing, pun intended. What seems
what types of information you should be looking for
like low liquidity for one stock might be high for
when choosing stocks or ETFs.
another. For example, GOOGL and AAPL are higher-
Factor #1 - Optionable Stocks & Liquidity Filters priced stocks, which means you don't need to sell as
many covered calls on them to generate high option
By now, it should be evident that you cannot use a premiums. Other lower-priced stocks like WFC or BAC
covered call option strategy on a stock that isn't, well, leave room for you to not only purchase more shares
optionable. It'd be like trying to drive a car without at a lower price but then require that you sell more
wheels; it's just not going to happen. Therefore, the covered calls to capture the same premiums as selling
easiest and quickest way to filter the possible universe one or two calls in higher-priced stocks. There's no
of stocks and ETFs down is to first look at the right or wrong answer necessarily since it's all relative,
availability of options. Second, the liquidity of the so here are the key points of focus when reviewing the
options contracts for each underlying. liquidity of the options market.
Surprising as it may seem, many companies still do First, make sure there are a variety of contract months
not have a derivatives market for options contracts. available. You want to see many months of options
Even if you wanted to execute a covered call strategy, contracts in the option pricing table. Multiple months

tell us that there's a strong demand from investors for use as you scan for possible investments. You'll learn
buying and selling options in various periods. If the to quickly recognize excellent liquidity by merely
stock or ETF has weekly options, that's an even looking up and down the options pricing chain.
stronger indication that the market can handle and
support a larger group of investors. If these two metrics hold up, the tight or narrow bid/
ask spreads will surely follow. This means better
Second, you want to check the liquidity of the front- pricing and easier fills for your covered call. To help
month expiration contracts, which expire in the next train your eyes, we've pulled together some bad and
30 days. These will typically be the most active great liquidity examples below.
contracts, and ensuring their liquidity is vital to a
possible covered call options strategy. The two Bad Liquidity Examples
metrics we'll look at specifically to judge the liquidity First up is an old favorite of ours that we use often in
of a market are Volume and Open Interest. courses and webinars. Mainly because the ticker
symbol is GOOD, and yet the liquidity is anything but
Volume shows us the activity of the options market on
good. In fact, it’s nearly non-existent.
a given day, and open interest shows us the depth of
the market for contracts still outstanding. You might
think about these two metrics as measuring the depth
and speed of a market, like that of a raging river - the
deeper and more active the market, the better.
Shallow, stale markets (swamp-like) should be avoided
and offer minimal opportunity. Ideally, there should be
thousands of options contracts in volume for a given
day and tens of thousands of contracts in revolving
open interest across multiple strike prices.
For clarity, each strike price doesn't need to have

precisely 1,000 contracts traded in volume or exactly
5,000 contracts of open interest. What we mentioned
above are just guidelines or road markers you might

Notice that both the volume and open interest for the below anything we would touch. Plus, the volume
closest ATM call options, the $25 strike price, in the reading of zero suggests at the end of the trading day,
next month are lifeless. Just 6 contracts are floating when we grabbed this screenshot, that the market for
out there somewhere. Yes, the stock is optionable, but options on NNN is extremely quiet.
the options are illiquid. If you think that this pool is
Great Liquidity Examples
deep enough to swim in then you’re sadly mistaken.
Enough with the garbage liquidity examples. Let’s
Next up is NNN, a fairly large company that is held
review some amazing liquidity examples. Naturally, the
within many ETFs and Indexes as well as traditional
first one we’ll review are the call options for SPY,
investors. Here we’re showing the closest ATM call
options which are the $60 strike. Yet, once again, we which has the most liquid options market of any ETF
or stock. Here we’re showing the closest ATM round
see the lack of liquidity in the options contracts.
strike call option at $310 strike price.
Admittedly, it’s not as bad as GOOD on the previous

page, but it’s certainly not liquid enough either. The
contract has much more open interest but it’s still far

SPY, in our opinion, should be your “north star” when got more than enough room to get contracts filled
it comes to scanning for liquidity. It sets the bar very without much of a struggle.
high with more than 55,000+ contracts of open
The question now is, do you always need to trade
interest and 24,000+ contracts traded today. Not this
week or yesterday; today! And this is only on a single tickers as liquid as SPY and GLD? Nope. The goal is to
distinguish between bad and great liquidity. So long as
call option strike price in a single expiration period.
you follow the general guidelines we’ve presented
Let’s pull up one more example and look at the call earlier, you should find it fairly easy to enter and fill
options for GLD, a major gold ETF. orders.
Factor #2 - Fundamental or Technical Analysis Filters
Filters for fundamental or technical analysis could

have been the number one item on our list for
choosing a stock. Still, we wanted you to focus on the
liquidity of the underlying options because, without
that, it'd be pointless to review the next steps. All the
analysis in the world would be worthless for a covered
call investor if you cannot trade liquid options
contracts on your prized stock pick, right?
Now, you're a pretty smart person if you're reading

this book, and chances are you've done well enough to
have some money set aside for investing purposes.
Most new covered call traders, therefore, are well-
Looking at the $139 call strikes, which is the closest
versed stock investors and already study or should be
ATM contract, we see both open interest and today’s
studying, company financials and earnings reports.
volume in the multiple thousands. This call option isn’t
Therefore, one of the first ways you can filter the
as liquid as SPY but it’s within our general guidelines.
universe of stocks to purchase for a covered call
If you are trading a handful of covered calls, you’ve
strategy is to use fundamental analysis filters. There

are many hundreds of filters you can use, and we don't simple covered call strategy, and you now have, not
dare pick any here that you would focus on since the one, but two ways to reduce costs basis and generate
best indicators can vary per industry or sector. income on an underlying which further increases your
Instead, we'll list some of the more popular filters chances of success. Multiple streams of income are
being used for you to explore in your spare time. always more stable and attractive in our book.
• Price to Earnings (P/E) Ratio Whatever you choose or however you analyze the
fundamentals of a company, if you plan on owning
• Price to Cash Ratio shares for the long haul, you'd better have a solid
• Debt to Equity Ratio understanding of the business, it's growth, the
industry they are competing in, etc. Don't invest
• Forward P/E ratio because you love the founder or CEO. And please
don't invest because of a tweet, post online, or article
• Price to Free Cash Flow
you read in the newspaper. Invest for value and
• Earnings Per Share Growth expected returns. Buying stock is buying ownership in
the company, and you should never forget this.
• Price to Book Ratio
The second way you could filter for possible securities
• Dividend Yield to purchase for your new covered call strategy is to
use a combination of technical analysis indicators.
• Cyclically Adjusted P/E (CAPE) Ratio
Technical analysis is a method of examining past
• Many more... market data to help forecast potential future price
movements. Using different tools, indicators, and
Personally, if we were forced to purchase long charts, investors can often generate signals that
underlying shares, we'd choose companies or ETFs leverage current and historical market data to
with a long history of paying a stable, high-yielding anticipate a stock's future or projected path.
dividend trading at a low CAPE Ratio. An ETF yielding
4-5% per year in dividends helps to reduce costs basis Often this means that you'll be trading in and out of
and smooth returns over time. Couple this with a underlying stock more often and on shorter
timeframes. It likely won't be day trading but rather

what we call "position trading," in which case you What's the moral of the story for technical analysis?
might hold a stock position for a few weeks or months First, you don't have to use technical analysis to trade
between entry and exit signals. During this time, you covered calls. Are they required? Nope. Can they help?
can sell covered calls to further increase your You bet. And if you are going to use them, it's
probability of success on any long stock positions you essential to use the best indicators and settings.
enter. Anything else could be damaging to your likelihood of
success. Once again, we did the research for you and
This all sounds very sophisticated and cool. Use some published all our findings in the ground-breaking
secret indicators that predict stock movement while publication called The Signals Report, which you can
you're sipping drinks on a beach somewhere. The truth find on our website.
is that most technical analysis indicators are terrible
predictors of market direction and stock returns. How Factor #3 - Covered Call Yield & Return Filters
can we be so bold as to make this claim? Well, we had
If you've checked all the items above and find a
our research team spend an entire year testing the
company or ETF with a liquid options market that you
validity and predictive power of the top 17 most
popular technical analysis indicators. We tested and want to own, the last filter is to run a couple of
simulated trades. These allow you to double-check the
analyzed more than 1,476 indicator variations over 20
covered call yields and returns you might expect
years to see which worked and which did not.
moving forward. Although you might be very excited
Not surprisingly, only a few indicators and specific to get going by jumping in with both feet, we highly
settings generated reliable signals and excess returns suggest you do some simulated trading over the next
above the market. To put even more context on this, couple of weeks or months.
less than 5% of all the variations we tested had
You want to get a decent idea of what the option
predictive power in a stock's future direction more
premiums are you'll be receiving if you start selling
significant than 50% accuracy. In English, this means
covered calls. It might take some monitoring, and you
that the vast universe of indicators out there, for all
intents and purposes, are less predictive than flipping should watch how option pricing changes during a
couple of different expiration cycles for your target
a coin. Of those in the 5% bucket, only a tiny handful
stock. Besides, if you're planning on investing in stock
was significant enough to use for investing purposes.
for the long haul, what's another month or two of

analysis to make sure it's the right move for a covered dividends and cost basis reduction overall each year.
call? We think you'll find that patiently observing for a Not too shabby, right? Nope, seems pretty attractive.
small period of time results in more confident decision
There you have it, the three primary factors we believe
making, and ultimately more profitable investments.
you should review and analyze when choosing your
What should you look for, or what benchmark should underlying stock for a covered call strategy. We meant
you use then for covered call yields? As far as targets for this to be a little subjective on many levels, as it
are concerned, a great guideline would be to collect should be. Trading with covered calls is a long-term
around a 1% premium to stock price yield per month. investment in stock, and you should make sure that it
We use the word "collect" here specifically as we're fits within your personal goals and risk tolerance levels
referring to the option premium or option price at the before moving forward. In the next section, we'll help
time you initiate the covered call. For instance, if a you decide which expiration date or contract month to
stock is trading for $100 per share, you might have a target.
target to collect approximately $1.00 of option
Step 2: Select Expiration Date or Contract Month
premium per month, on average, selling covered calls.
The premium you collect may or may not be the final Now that we've got a stock picked and own shares in
the underlying, we'll start using some live examples to
profit on a single position.This is a general guideline,
demonstrate how you might think about choosing the
and you can, of course, go higher or lower than this
expiration date in which to sell your covered call.
figure. As a starting point, you could sell the 30 Delta
Before we keep moving, we want to highlight the
call options in the one-month expiration contracts as
the basis for your analysis. Recall this is the setup that general impact of theta decay (time decay) and
implied volatility on options pricing again. Recall that
the CBOE uses currently that outperformed the S&P
an option's premium or price may react differently to
500, though we know there are better setups we
theta decay and implied volatility in various expiration
could possibly use.
periods.
Once you add this to the 3-4% dividend yield per year,
provided your stock doesn't get called away, you will Longer-dated (back-month) options contracts erode
at a slower pace than shorter-dated (front-month)
be receiving a nice regular income of around 15-17% in
options contracts. A call option 90 days from

expiration will lose less value per day than the same Notice the relative option premiums of the $291-294
strike call option 30 days from expiration. The front- OTM calls on the right side of the pricing table. They
month contract is running out of time, and therefore, range from $2.23-0.98 per contract.
the theta decay speeds up as expiration nears.
When it comes to implied volatility, the roles are

reversed. Longer-dated (back-month) options
contracts react more to changes in implied volatility
than shorter-dated (front-month) options contracts.
This is because a small change in implied volatility
now, which is extrapolated out over a longer time
period, could have a major impact on the expected
stock price.
A call option 90 days from expiration will witness its

price rise much higher on a relative basis due to
increasing implied volatility than the same strike call
option 30 days from expiration. The front-month
contract is less reactionary to changes in implied
volatility, which may or may not have enough time to
play out before the expiration date. Given a choice,
we'd always prefer to start selling covered calls when
implied volatility is high, and option pricing is high as a
result.
The back-month contracts expiring in October are
Good so far? Great! Now, let's look at some call
approx. 50 days from expiration. Notice the relative
options in different expiration months for SPY. The
option premiums of the $291-294 OTM calls on the
front-month contracts expiring in September are
right side of the pricing table. They range from
approx. 22 days from expiration.
$3.60-2.18, significantly higher than the September

contracts. The additional premium is mainly due to the order entry or goes to zero by expiration. Granted, we
additional time and volatility (extrinsic value) given to also don't want this to happen at the expense of the
the back-month options. stock shares crashing, but right now, we're just
referring to the short call option contracts,
independently of the underlying stock.
So how far out in time should you sell covered calls?

22 days or 50 days? Well, it depends. It may seem like
both front, and back-month options contracts have
benefits and drawbacks, and you'd be right. The
answer then is that you need to align the expiration
date or contract month with both your willingness to
monitor and manage the position and the available
premium to be collected. Our Covered Calls
Performance Research Report will also help guide
your decision-making process after reviewing the
performance of various expiration periods.
Step 3: Choose the Call Option Strike Price
Deciding the final strike price for selling a covered call

might be one of the harder considerations an investor
has to make for this strategy. Sell a call option too
close (high delta), and you collect a high premium but
give the stock very little room to move before capping
Keep in mind at this stage that since we are selling call
your profits at the lower strike price. Sell a call option
options, we want to generate the highest return on the
too high above the stock price (low delta), and you
option contract as possible while also not impeding
collect a lower premium but give the stock more room
the upward mobility of the stock. We achieve this
to rally higher before you cap your gains with a higher
when the option premium quickly falls in value after
strike price. There are risks and rewards to each style

Figure 2: Value of $1 Invested - CBOE Buy-Write Index Return (BXM)
$30
$25
$20
$15
$10
$5
SPX BXMD BXM

$0
1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018
or flavor you choose so take your time picking on aggressive covered call strategy was 8.50%, with a
that’s right for you and your portfolio. standard deviation or portfolio volatility of 10.60%.
These metrics are both less than the 30 Delta call
ATM Covered Call Performance (Fig. 2) option strategy (BXMD) and the S&P 500 itself. It
One guiding light might be the CBOE's Buy-Write proves that selling closer ATM (high delta) call options
Index (BXM), which sells an ATM call option on the does help to reduce volatility in the combined
S&P 500. Effectively this is selling a 50 Delta call strategy, but at the sacrifice of overall gains and
performance. Naturally, there's a delicate balance here
option every month, and the results prove the point
we outlined above. The annualized return of this that you need to find that works for you.

Continuing with our examples, we'll again look at the The closest strike price to our target 30 Delta and 70%
same call options in different expiration months for probability of success level in the back-month
SPY. Only now, we'll assume that we'd like to sell a contracts expiring in October is the $293 call options
covered call near a 30 Delta with a target probability with a price of $2.61 per contract.
of success around 70%. The closest strike price to our
target 70% success level in the front-month contracts
expiring in September is the $292 call options with a
price of $1.73 per contract.
Which one do you pick? Tough question for sure.

Ultimately the decision is either driven by data, from
backtesting research, or a personal decision based on
your risk profile and need for either growth or security

with your positions. Here's the trade-off you need to
consider which might help steer you in the decision-
making process.
If you sell the front-month options, you will collect a

lower premium at a strike price that's only $2 above
the current market price. In exchange for the lower
premium and higher risk of the stock breaching the
strike price, the stock only has 22 days until expiration,
and time is running short. If you sell the back-month
options, you will collect a higher premium at a strike
price that's $3 above the current market price. In
exchange for the higher premium and further out
strike price, the stock now has more time, 50 days
until expiration, to move against your short call.
Conclusion
If you've followed the first three steps outlined in this

chapter, you're now ready to enter your first covered
call trade officially. With all the pieces together, the
process of actually placing the order in your broker
platform should be relatively straight-forward. You
already own the stock (or are purchasing it) and have
selected your target expiration date and strike price of
the call option contract. Now, place the order and turn
the page. If you still need help or have questions,
please reach out to our team at Option Alpha.

Chapter Four
Position Management
NOTE: In the Options Basics chapter, we walked
through a similar framework, but at that time, it was
If you've reached this chapter, you should explicitly dealing with single long call and put options.
have your new options strategy executed In this exercise, we'll approach this only from the
standpoint of a covered call investor.
and working its magic. In essence, you've
made it. You're an options trader now. To help build some context for our discussion, let's
assume the following options pricing table exists for
Earlier in this book, we reviewed the overall strategy of the ticker EWW (iShares MSCI Mexico ETF):
a covered call, proved using the CBOE data that they
can outperform the major stock market index, and
finally helped you determine the right expiration
months and strike price ranges to target. And since
you're on a new level with your trading, we'll assume
you're also smart enough to know that it's not always
roses and sunshine trading covered calls.
Stocks do move down from time to time - shocking

right. So, what happens now? Now that you've got this
covered call strategy working, how do you manage or
adjust the position if it starts to go wrong?
First, don't worry; we wouldn't have carried you this

far to abandon you now. In this chapter, we're going to
take a look at all of the different scenarios that could
happen with a fully executed covered call position and
how you should react or adjust your position if
necessary. Remember to always take your time and
work slowly. There's never a need to rush the process.
Chapter Four Option Alpha © 2019. All Rights Reserved. 44 of 65

With this pricing table in front of us, we’ll also assume Where appropriate towards the end of this section,
the following covered call strategy is executed. we'll also suggest ways to hedge or adjust the trade to
reduce risk. Let’s start with the best outcome.
1. ETF is trading currently for $51.73 per share.
Outcome #1: Stock Rallies Above Strike Price
2. You purchase 500 shares at $51.73 for a total cost
of $25,865. One of the most common concerns options traders
have when setting up a covered call strategy is what
3. Your target for the covered call is the 30 Delta happens when the stock, EWW, in our example, rallies
strikes representing a 70% probability of success. above the strike price of the short call option you
4. You sell the $52.50 strike call options for $0.89 in sold? Does this mean that your shares will be "called
away" or exercised and assigned immediately to the
option premium per contract.
option buyer? Should you buy back the short call
5. You sell five contracts that cover the 500 shares option to keep the stock position or let your stock be
you just purchased. called away? Well, there are several points we need to
cover to answer these questions.
6. The call options expire in 22 days from today.
First, the most important thing to understand is that
7. The cost basis on the shares of the ETF is reduced just because EWW rallies higher, does not mean you
to $50.84 because of the premium collected. will automatically lose your long shares. Most
8. The total premium of $445 is subtracted from the assignment of stock by the call option buyer happens
original total cost to a new, net total cost of the week of expiration, and more specifically, the last
$25,420. few days of expiration. At that point, the option
contract has little to no extrinsic value left. So, if the
9. You have reduced your cost basis on the EWW stock rallies above your strike price but you still have
shares by 1.70%. 20 days to expiration, there's a high probability you
will not get assigned by the option buyer.
Now that you’ve got your trade setup and working in
EWW, there are five possible outcomes and With 20 days left, there's still a decent amount of
corresponding potential actions you could take. extrinsic value left in the contracts, and the option

buyer would forfeit that extrinsic value by assigning potential profit possible in a single expiration period.
the option contract in exchange for shares early. They Go ahead, pat yourself on the back. The reason you
won't do that because it would be financially unwise got paid a premium selling a call option, $445 in total,
to do so. However, if you were to wait right up until is because you forfeited your right to any profit on the
expiration and the stock was still trading higher than stock beyond the $52.50, and that's okay.
your strike price, then you are at greater risk of your
Hitting lots of singles as opposed to swinging for
stock getting assigned and called away.
home runs is an excellent strategy for generating
Let's assume for whatever reason that your EWW consistent, reliable income. And, well, higher overall
shares are exercised and assigned to the option buyer, returns with less risk in the process. Need a refresher?
and you no longer own the underlying stock. Well, Go back two chapters and re-read the performance of
remember when mentioned earlier in the book that covered calls vs. the S&P 500.
this might be one of the best-case scenarios? Having
Outcome #2: Stock Rallies, Stays Below Strike Price
your stock assigned is not a bad thing; in fact, it might
be the ultimate goal because, after all, you wanted the This outcome is the second most favored among
stock to rally higher, didn't you? That said, some covered call traders. If EWW rallies but the shares
people get upset that they didn't participate in the remain below your strike price of $52.50 at the end of
new higher stock price above the strike price level. the expiration cycle, then the options contracts expire
And we understand that concern, but these strategies worthless, and you don't need to do anything. As the
have capped upside profit potential in exchange for a call option seller, you get to keep the $445 premium
much higher probability of success. You can't have you collected from the buyer as profit, and you also
your cake and eat it too. get to keep your long shares of stock since the stock
never breached the strike price. The stock value
The profit you can receive is limited to the difference
increased, and you kept the entire option premium as
between the $52.50 strike price and the $51.73 stock
profit, win-win. Now, go sell another covered call and
price when you purchased the shares, plus the credit
received from selling the out-of-the-money call, $0.89. repeat the process all over again next month.
If EWW rallied well above your $52.50 strike price, and
your stock is assigned, you just captured all the

Outcome #3: Stock Moves Sideways doing yourself a big favor when it comes to cost basis
in this unfavorable scenario.
A highly likely scenario is that EWW trades in a
sideways range around your original entry price. Because you sold a call option for a premium, your
Remember that markets are both cyclical and new break-even point, or cost basis, on the stock was
relatively random. Maybe up a couple of days here and lowered to $50.84 per share. Therefore, the stock
there, down some other days, ultimately moving could effectively drop from $51.73 to $50.84, and you
sideways with no clear direction. If this happens, then would not lose money overall on the combined
this outcome is probably the third-best one you might covered call strategy. Any drop below $50.84, and you
expect. would lose on the overall strategy due to the decline in
the underlying stock shares. At expiration for this
At expiration, you didn't lose any value on the stock fourth outcome, the short call option is now far out-of-
you own, but you also get to keep the entire $445 the-money and will expire worthless, freeing you up to
option premium as profit from the short covered call. re-establish another short, possibly at a closer strike
Sure, you didn't see the stock rise in value, yet you got price in the next month.
paid for waiting around, selling the covered call, and
reducing your cost basis on the shares in the process. All that being said, you should continuously re-
Now you can re-establish a new set of short call evaluate the EWW position and make sure you are still
option contracts in the next expiration month and comfortable owning shares. The cost of owning the
repeat the entire process. shares takes up the bulk of capital for the position.
Therefore, the stock itself is the most critical factor to
Outcome #4: Stock Trades Lower, Continues Falling monitor.
Let's be honest, rational adults with each other for a If you decided you want to sell the stock, you need to
moment. There's a 50/50 chance that your beloved first close and buy back the short call option or wait
EWW shares go down at some point during your until your call option has expired. Exiting the stock
covered call expiration cycle. Yes, this means that not position while leaving the short call option open and
all stocks go up, and it will happen to you at some working would expose you to a short naked option
point. But since you are selling covered calls, you're position. This translates into potentially higher margin
requirements and additional risk you may not want.

Outcome #5: Stock Has Upcoming Dividend The call option buyer would choose to do this in order
to purchase shares from you and collect the upcoming
This scenario is specific only to those stocks and ETFs dividend payment. Seems rational, right? But how can
that pay dividends. In our example, we selected EWW you tell if the particular strike price of $52.50 that you
specifically because it does pay dividends quarterly, in are holding is at risk of early assignment of your
which case we can walk through the scenario without shares? It's straightforward, actually.
changing ticker symbols. Before we go any further,
please understand that dividend payments and early To determine if your short call option is at risk of early
assignments as a result of dividends will not occur as assignment, look at the price of the corresponding put
often as you think it might. option contract at the same $52.50 strike price. Short
call options are at risk only when the value of the
You should always be aware of when your stock or corresponding put option at the same strike price of
ETF pays monthly or quarterly dividends. Not only $52.50 is valued less than the dividend payment
because you'd want to collect this money as the stock scheduled. You should re-read that last sentence
owner, but also because you could be at risk of early again, potentially two or three more times, because it
assignment. How does it work, and why should you might seem a little complicated at first, but it's a
care about dividends payments and dates as a fundamental concept.
covered call investor? Let's discuss.
The question naturally then is, what does the put
When a stock or ETF, like EWW, is about to pay an option strike price have to do with our covered call
upcoming dividend, the risk of early assignment option? Think back to the first chapter on Options
increases dramatically. The kicker is that the risk of Basics and recall that the goal of the call option buyer
early assignment only impacts those call option strike on the other side of your contract originally was to
prices that are deep-in-the-money. These would be take a risk defined, bullish position on EWW stock.
the call option strikes that are below the current stock Their risk was limited to the premium they paid you of
price. These contracts could potentially be at risk of $445, and in exchange, they get all the upside
early assignment because the call option buyer, on the potential beyond the $52.50 strike price and their
other side of your trade, might be motivated to respective break-even point.
exercise their contract early.

If they now are interested in assigning the option The call option buyer could exercise the call option
contract, they would only do so when they can use the contract, purchase shares at the $52.50 strike price
money collected from the dividend to immediately from you, get paid the dividend of $0.35 per share,
purchase a long put option at the same strike price as and use $0.30 to immediately purchase a $52.50
the original call option. It sounds complicated, but it's strike put option contract for protection. Effectively
not. The call option buyer is willing to go through the getting them back into the same risk defined, bullish
exercise process to assign shares; however, only if they position in EWW only now a little richer by $0.05 per
can use the money collected from the dividend to share. Bing, bang, boom.
become risk defined again.
Alternatively, let's assume that the same stock price
Holding long shares of stock while also purchasing a setup exists as above, only now the corresponding put
long put option for protection is the same synthetic option at the $52.50 strike price is trading for $0.50
position as a long call option. It's the same payoff per contract. In this scenario, the call option buyer
diagram, just constructed with different components. would not exercise their contract and assign shares. It
In this case, all the call option buyer would do is use would cost them more money overall to buy shares at
the money from the dividend payment to finance or $52.50, collect the dividend of $0.35 and then pay
pay for the purchase of a put option contract for $0.50 to purchase the put option protection. It would
protection against the stock shares. be financially a net loss plus they are better off to
keep the call option contract and forgo assigning you,
Let's walk through an example assuming that EWW is the call option seller.
now trading at $55 per share, making your $52.50
strike call option an ITM position. This week EWW It should be evident now that not all in-the-money
announced it will be paying a $0.35 dividend per (ITM) call options are assigned just because they are
share. On the day before the stock trades ex-dividend, ITM. This is a common misconception about the early
the corresponding put option at the $52.50 strike assignment of a short call option as a result of
price in the same expiration period as your short call dividends. Just because your option is ITM around the
option is trading for $0.30 per contract. In this time of dividend payment, doesn't mean you are at
scenario, you would be at risk of early assignment of automatic risk of assignment. It is only if your call
your call option contract and here’s why. option contract is ITM, and the corresponding put

option at the same strike price is valued or priced less moving it closer to where the stock is trading. You
than the dividend payment. may often hear the phrase "rolling down," which is just
fancy trading jargon that means closing one strike
Have a look at your broker platform on the day of ex- price and re-opening another, lower strike price,
dividend to check if you are at risk of an assignment typically in the same expiration period.
or not. If you are at risk, then you either need to close
out the call option contract or roll it over to the next Using our primary example for the chapter, let's
month, discussed next, where option premiums are assume EWW dropped to $49 per share, below your
higher. Assignment happens on the day the stock goes $50.84 break-even price. At this point, your short
ex-dividend so make sure you know when this is so $52.50 call options which you sold for $0.89 might
you can be one step ahead and not caught off guard. drop in value to just $0.20 each. You could then
choose to repurchase these $52.50 call options and
Covered Call Adjustment & Rolling close them for a quick $0.69 profit and immediately
It's easy to sit back and watch the profits roll in as the re-sell a closer call option strike price, say the $51
stock you are trading rallies higher during the strike price that is now quoting a price of $0.70 per
contract.
expiration month. This happens about 50% of the time
and requires no effort on your part. Go ahead, keep The net impact by adjusting your call option strike
kicking your feet back and sipping your chilled drink. price lower is that you took in an additional net credit
The other 50% of the time, the stock falls during your of $0.50 for each option rolled down. This reflects the
expiration period. When this happens, there are a premium received from selling the $51 calls at $0.70
each, less cost to buy back the $52.50 calls at $0.20
couple of ways to adjust and manage the position to
reduce risk. Note, we're not talking about fully turning each. Your new overall credit from both call option
the position around into a winner all the time, but sales, the original entry and this new adjustment, is
instead taking a potentially significant loss and cutting $1.39 per contract, or $695 in total.
it down into a smaller loss. The real "magic" when using this type of adjustment
technique is that you are taking advantage of the
The first way to reduce risk is to adjust the covered
call strike price in the same expiration month by downward move in the market by increasing your
overall credit. The adjustment reduces your cost basis

on the EWW shares even lower and moves your break- the next expiration month pays the same amount of
even point down to $50.34 from $50.84. With the money as a closer strike price at $51 in the front-
stock trading at $49, you are within striking distance month expiration we analyzed above.
of a profit on any small rally in the shares.
The process of rolling the call option out in time is the
Yes, at the moment, you're still losing money. But had same mechanically as it is for rolling the call option
you not executed the adjustment, you would be down down. You simultaneously buy back and close the
even more money as your old break-even price was $52.50 call options that expire in 22 days while re-
$50.84. The new break-even price is $50.34. Pretty selling new short call options at the same $52.50
cool, right? And you can keep rolling down your call strike price in the next contract month that expires in
strikes as needed during the expiration month multiple 50 days, for example. The trade-off is that by rolling a
times if you want. call option out to a further expiration month, you
might have to wait longer for your profit on the
The second way to adjust covered calls is to roll the premium to be realized. On the other hand, because
existing call options from the current front-month you didn't move the strike price of the call option
expiration to the next, or further out, back-month lower, you are leaving more room for the stock to rally.
expiration. In the adjustment example above for EWW,
we rolled call option strike prices down from one Conclusion
strike to another strike in the same month. In this
Whichever method you favor as you start monitoring
second adjustment technique, we are instead rolling
and adjusting covered call positions, recognize that
the call option strike out in time to give the stock
more time to recover potentially. being proactive is crucial. When the stock drops and
you roll your short call option either closer and down
You'll often find that rolling out in time to the next or out to the next month, it allows you to increase
month accomplishes the same goal of collecting an your overall credit in the position and ultimately
additional credit without having to sacrifice your reduces risk. Is one technique more favorable than the
upside potential selling a closer call option. This works other? Not really. There's no perfect answer, and each
because an option contract with more time until situation is going to be a little different. As always, you
expiration is more valuable, all else being equal. So have the option, pun intended, as to which adjustment
you might find that the same strike price of $52.50 in technique seems most appropriate for you.

Chapter Five
Synthetic Strategies
Long-Term Equity Appreciation Security (LEAPS). It
acts as a synthetic in place of purchasing underlying
What if we told you that as much as you stock or ETF shares. You may also hear people call this
might have fallen in love with covered calls strategy a "Poor Man's Covered Call" or "Skinny
Covered Call" as well as many other names, but the
during our amazing, self-admittedly,
concept is the same. Instead of purchasing 100 shares
blueprint in the last couple of chapters, of stock, purchase a single (one) deep ITM call option,
there were better alternatives? that controls 100 shares, and replicate a stock position
for less money.
Alternatives that required less money to get started
and performed practically the same, and in some Why do this? Well, there's no debating that the capital
cases, much better long-term. Alternatives that gave requirements for stock ownership can be incredibly
you the ability to diversify across more stocks and high. For example, the Russell 2000 Index EFT (IWM),
ETFs and leverage the full power of options. Starting is currently trading at approximately $172 per share at
to salivate yet? Well, it's true, and we'll show you how. the time of this writing. To purchase 100 shares of
IWM, you would need to invest at least $17,200, a
In this final bonus chapter, we'll explore the two main
figure that is 70% higher than the average brokerage
alternatives to trading covered calls without the account opening balance in the US. All that money so
requirement of purchasing the underlying stock. Yes, you can sell one covered call against the stock while
you don't have to outlay thousands of dollars to buy still carrying the full downside risk of the market
stock to trade a covered call option strategy. Together
moving lower? No thank you. It seems like a lot of risk,
let's examine these alternatives we’ll refer to as
in our opinion, to gamble on a single ticker that may
covered call “synthetics strategies.” or may not work out? We're sure you can see our
Synthetic Strategy #1: LEAPS Options hesitation with stock ownership.
The first synthetic covered call replaces long shares of If we agree then that stock ownership may not be the
stock with the purchase of a single deep ITM call most cost-effective way to build a covered call
option in a far-dated back-month expiration. This type strategy, what else could we do to replicate the 100
of call option contract is commonly referred to as shares of stock? We could use an option contract of
Chapter Five Option Alpha © 2019. All Rights Reserved. 53 of 65

course! Remember that every one option contract Thankfully, we can use the option greek Delta to help
controls 100 shares of stock. Specifically, we could us estimate how reactive a particular call option strike
purchase a call option with a high Delta value, which price will be to a $1 move in the underlying stock. A
would replicate similar performance of the underlying call option with a Delta of .50 will behave as if you
stock without having to buy shares outright. This is owned 50 shares of the underlying stock. Your single
where LEAPS are used by sophisticated options call option still controls 100 shares of stock at
traders to create a covered call synthetic. expiration, but the day to day price movement of the
option contract moves as if you owned roughly 50
As mentioned, LEAPS are long-term or back-month shares of stock. Call options with a Delta of .70 will
expiration contracts. How far out in time exactly? Well, behave as if you owned 70 shares of the underlying
that's up to you to decide. Generally, any expiration stock.
more than six months out from today's date is a
reasonable basis for starting to analyze a synthetic Ironically, because we know where your mind is
position. If it's currently January, then you might look already going, Deltas of 1.0 will not exist until you get
to purchase call options in July or further out in much closer to expiration due to the extrinsic value of
November if you wanted. The further out you are LEAPS. Therefore, we want to potentially target a
buying the call option LEAPS, the more expensive the Deltas around .80 to .90 whenever possible. This will
options contract or premium will be, but the more give you the ability to replicate 80-90% of the stock
time you have to see the stock move favorably for you. move with a fraction of the cost compared to
purchasing the shares outright. Amazing right?
Once you identify the expiration month you are
comfortable trading, you'll look for a deep ITM call Sticking with the IWM example from earlier, let's look
option strike price to purchase. Recall that any call at a LEAPS setup in an expiration seven months out
option that is deep ITM will have a strike price that is from now, at the time of this publication. The options
lower than the current stock price. The deeper ITM the pricing table for IWM is shown on the following page
call option strike price, the lower the strike price from for the call options which expire in March of next year.
the current stock price, and the more the option Notice how different the option prices are for
contract price will behave and trade as the underlying contracts this far out in time to what we've seen
shares would. earlier in this book.

purchase a deep ITM call option of just $2,092, which
controls the same 100 shares. That's an 87% discount
on the cost of purchasing the shares. As far as capital
efficiency is concerned, need we say more?
Plus, there's another added benefit embedded here

that we haven't even discussed; black swan or crash
risk. What if IWM crashes? What if the stock goes
down 20% this week and trades at $137 for the next
seven months? Does stock or a long call option give
you more protection?
Your option contract has defined and limited risk,

whereas the stock shares carry all of the downside
risks of a market crash. Trading the call option
contract during this 20% drop would only leave you
exposed to a $2,092 loss, or the value of the option
contract, and nothing more. Holding long shares of
stock during a 20% drop would yield a loss of $3,440,
assuming IWM doesn't keep falling. Do you now
understand why trading and investing in the
The $155 strike call options, which are well below the underlying stock is so inefficient for investors? It's a
current share price and considered deep ITM, are at an poor vehicle for controlling and managing risk.
.80 Delta and are trading for $20.92. In real dollar
terms, each call option contract would cost $2,092. With the deep ITM call option at the $155 strike price
now acting as our synthetic stock position, then the
Now, let's pause here before we go any further and only remaining step to complete our covered call
look at the trade-off between buying the stock strategy is to sell the front-month OTM call options
outright and buying this deep ITM call option. The cost above where IWM is trading. Using the pricing table
of 100 shares of IWM would be $17,200 vs. the cost to for the expiration 22 days from today, we might look

to sell the $176 strike for $1.38 per contract. This expiration comes in 22 days, just re-sell another OTM
additional premium reduces the cost basis on the call option in the next front-month contracts while
price of the deep ITM call option we purchased from holding the same deep ITM call option in the further
$20.92 to $19.54 overall. A 6.59% reduction in cost. out expiration month. Repeat these mechanics every
month moving forward to maintain the synthetic
position.
Freeing up the additional capital with this one

synthetic gives you much more flexibility to diversify
your portfolio with other covered call positions or hold
cash in reserve. It always fascinates us that more
investors don't think about or use options in this
manner. The math and numbers certainly don't lie. But
that's why we're writing this book after all! To help
guide and education you on the choices available.
Now, are you ready for an even better strategy than

the one presented above? Oh yes, I've been saving
one of the best for last. Enter the pure option seller.
Synthetic Strategy #2: Short, Naked Put Options
The final and absolute best synthetic alternative to a

covered call strategy, is to sell short put option
contracts. Just mentioning the idea of trading short,
naked options strikes fear into many traders as they
are inherently associate it with being high risk and
There you have it, a synthetic covered call position foolish. On the contrary, we believe, and the data
using LEAPS options with a fraction of the money supports, that stock ownership is high risk and foolish.
invested and significantly lower risk. And when

Whatever prior connotations or beliefs you held about Recall from previous chapters that a covered call
trading naked, undefined risk or uncovered strategies, strategy purchases long stock and then sells an OTM
leave them at the door for a couple of minutes. We call option above the market price. The blending of
need you, and your portfolio needs you to keep an the two components creates the red payoff line
open mind about this as we walk through the setup. shown; an upward sloping payoff until the strike price
Once again, the numbers don't lie on which strategy of the short call option and then a flat payoff line at
ultimately generates the best return metrics, and any stock price above that level.
carries the least risk.
It makes rational sense why the red covered call payoff
Before we reveal the performance of selling short puts line flatlines or levels out at stock prices anywhere
to trading covered calls, let's discuss how and why this above the strike price of the short call option. At that
acts as a synthetic alternative. To understand any point, the stock gains are offset on a one to one ratio
synthetic strategy, you need to understand the payoff by the short call option you sold. This is the trade-off
diagram of the core, or traditional, covered call for executing a covered call strategy, limited upside
options strategy shown again below. potential beyond your strike price in exchange for a
higher probability of success overall by collecting the
option premium and reducing your cost basis on the
Long Stock
stock position.
Profit
To create a viable synthetic position that mimics that

Covered Call
of the covered call strategy, we ideally need to find an
options strategy that generates the same payoff line
shown to the left. If another strategy generates the
same payoff line, then we can use it as a reliable
synthetic, assuming it has a better risk and reward
profile.
Loss
Short Call As it turns out, a short, naked put option creates

Low Stock Price High Stock Price precisely the same payoff diagram as a traditional
covered call. Upward sloping to the right, then levels

off at some value representing the same defined profit To complete the synthetic trade, all you would do is
or limited upside characteristics of a covered call sell this single (one) put option contract and nothing
strategy. Depending on the strike price of your short else. Don't purchase the underlying stock, don't buy
put option contract, the payoff diagram would be deep ITM call options. Just become the option seller
nearly identical to that of a covered call. Crazy cool. of the $172 strike put contract. That’s it.
Profit
Short Put
Loss
Low Stock Price High Stock Price
With this new synthetic starting to take shape, let's

look at an example using the same IWM position we
used earlier. To collect as much premium as possible
and mirror the payoff diagram of the covered call, let's
sell the at-the-money (ATM), or near ATM, short put
options. The $172 strike price is currently ATM, is
quoted at $1.75 per contract, and expires 22 days from "But Kirk, how can we sell something we don't even
today. own yet?" Great question, and it brings up some
critical points. First, you have to change gears

mentally here a little and now think about the impact the stock is trading at currently, say $171 per share.
of this short put option contract from both the buyer You have a net loss of $1 on the stock shares since you
and seller perspective. Fire up the brain cells from the had to buy shares at $172 when they are only worth
Options Basics chapter about the rights and $171. But you forget something important. When you
obligations of options contracts as opposed to the account for the option premium you collected of $1.75
traditional stock investor's mindset of buying and initially on the sale of the put option contract, your net
selling shares. profit is $0.75 per contract, even after the assignment.
Do you see what happened? You made money even
A put option buyer purchases the right, but not the when the stock traded lower because you collected
obligation, to sell stock at the $172 strike price before the option premium as an option seller.
or at expiration. The put option buyer pays a premium,
$1.75 in this example, for this right to choose. If you are At this point, it might seem like selling put options is
now the put option seller in this example, you collect too good to be true? You collect a nice option
the $1.75 premium and have an obligation to purchase premium up front from the option buyer, and you
stock from the option buyer at the $172 strike price if don't need to own the stock. Effectively no money out
you are assigned on the contract. Easy so far and of your pocket to initiate the position; in fact, you're
should make logical sense. getting paid to initiate the trade, so what's the catch?
What could go wrong? Let's discuss this.
Next up is the slightly confusing part, or at least until
you read the next couple pages. Since this is an Understand first that dummies do not run brokers and
uncovered or naked position, it means you are not the options exchanges. You wouldn't lend money to
required to own the stock when you enter the trade. someone you knew had no means to repay the loan,
"Hold up Kirk, so what happens if I'm assigned and would you? The same thing generally happens in the
need to buy the shares from the put option buyer?" options market. The brokers and exchanges fully
understand the risk associated with any position or
If you were assigned, you would purchase the shares options contract. They wouldn't let you sell the single
from the put option buyer at the strike price of $172 put option contract without making sure that you have
per share. If you didn't want to hold the shares or enough capital to cover the risk should the position go
continue to own the stock, you could immediately sell wrong.
the shares back in the open market at whatever price

When someone decides to sell a naked, undefined risk If your brokerage account had a starting balance of
put option contract, the brokers have to determine an $10,000, your broker would earmark $3,615 for this
effective way of mitigating the risk to approve the short put option, which leaves you with $6,385 in
trade while also not requiring you to purchase the available funds for other trading or investing activities.
stock. So how do they do this? They calculate what is
NOTE: The figure referenced above is just the initial
called a Margin Requirement.
margin that is required to enter the position. The on-
You should think of Margin Requirements as really just going margin requirements needed to cover the risk
a fancy way of saying that you need to have "reserves" goes up and down depending on the stock price,
that are set aside in your account to cover potential implied volatility, option pricing, etc. For this reason,
losses on your short put option position. They don't we highly suggest you consider keeping short option
take the money out of your account; instead, they contract trading, like short put options, to a minimum
earmark a specific dollar value to the trade and reduce in your account and keep their position sizes small and
the remaining funds available for new trades. The manageable. As always, too much leverage can and
amount they will hold in margin depends on the will blow up your account if used incorrectly.
broker and your account type, but let's assume for
ATM Short Put Performance (Fig. 3)
simplicity it is roughly 20% of the value of the
underlying shares plus the option premium collected. At this point, we've talked at length about the capital
benefits of selling short put options. And while all of
Using our IWM example, if the stock is trading at $172
these efficiency points from a capital usage
per share and you were to sell the $172 put option for
$1.75 per contract, the margin that would be required standpoint have merit, the real question is, how does
the short put option strategy compare to the S&P
to execute this trade would be $3,615. The stock price
500? If a short put option performs worse than
of $172 X 20% + $1.75 option premium. Again, this
directly buying and holding the market index, there's
money is not taken out of your account but rather
no point in trading it.
reduces your available funds for trading to ensure that
you have enough money to cover the risk of this Remember the research the CBOE did on the from
position until it's closed or it expires. earlier chapters? Well, they also tested the
performance of trading just a single short naked put

Figure 3: Value of $1 Invested - CBOE Put-Write Index Return (PUT)
$30
$25
$20
$15
$10
$5
SPX BXMD BXM PUT

$0
1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018
option, referred to as the “Put-Write Index” (PUT), and continued to outperform the market in most periods.
it generated nearly the same annualized return with Since the goal of the PUT strategy is market-like
dramatically less risk and volatility in the portfolio. performance with less volatility, we would expect the
strategy to underperform slightly in bullish markets
If that wasn't enough, the put selling strategy also saw but outperform dramatically in bearish markets. This is
higher Sharpe, Sortino, and Alpha metrics than the exactly what happened and should continue to
S&P 500 and the Buy-Write Indexes that track covered happen in the future. Plus, the more efficient use of
call strategies. In Fig. 3 you’ll notice that the trajectory capital for a short put option frees you up to diversify
of the PUT strategy was both more stable and into a wider basket of underlying ticker symbols.

Selling short put options generated an annualized on the position was slowed, leading to potentially
return of 9.54% per year with a standard deviation, or longer holding periods.
portfolio volatility, of just 9.90% vs. 14.90% for the S&P
Second, selling option premium has been proven, both
500. The maximum drawdown was also much lower at
-35.50% vs. -50.90%, respectively. That's a 33% by our research as well as many others, to offer a
reliable and statistical edge over option buying
reduction in portfolio volatility and 15% more money
strategies due to implied volatility’s over-expectation
during a market crash scenario.
of option pricing. When options are priced, the
No matter how you slice and dice it, option selling was implied volatility that market participants expect in
a superior strategy when analyzing all facets of an the stock’s future movement is overstated in both
investment strategy. Short put options witnessed directions long-term. People assume that stocks will
higher returns, dramatically lower risk and portfolio, move higher or lower than they actually do. This
with a fraction of the capital exposure of long stock. creates a mispricing in option premiums, similar to
Why was this the case though? that of insurance contracts, which benefits those who
are net option sellers.
First, it might seem on the outside that the synthetic
covered call via the LEAPS offered a cheaper position Conclusion
cost-wise than the short put option. And while that
It has often been said that "People don't know what
could be the case in some contract months, the
they don't know." In the case of naked, undefined risk
additional transaction costs and structure of the
option selling, most investors associate them with
LEAPS alternative was a drag on performance.
having insanely high risk and high volatility in their
The LEAPS alternative required more transactions, at accounts because of what they have read online or
least one to purchase the deep ITM call and another to heard on the news. But when you look at the data,
sell the OTM call in the front-month expiration, while particularly from a third-party source like the CBOE,
the short put option only requires one transaction. the assumption that put option selling is risky is just
More transactions mean more commissions paid to the not supported. If anything, it should be viewed as one
broker, which drags down performance. Additionally, of the leading candidates for covered call synthetic
since LEAPS are a combination of options buying and strategies.
options selling, the net effect of theta or time decay

Final Thoughts…
Congratulations on finishing this book!
It's quite an accomplishment and one that many investors did not
reach. I'd even wager to say that just 10% or less of the people who
started reading this book made it to the end where you are now. You
should be very proud of yourself.
It's my sincere hope that this book was both an enlightening read as
well as a confidence boost in believing that you can, and are now
potentially even obligated based on the data, be able to beat the
market performance with less risk. It's not some mythical unicorn, but it
does take a healthy dose of discipline and consistency.
Options trading presents one of the most exceptional financial

opportunities for investors like you and me. I encourage you to use
what you have learned in this book as the foundation from which to
keep pushing forward and exploring new options strategies and new
ways of generating income.
Until next time, Happy Trading!

Author
Kirk Du Plessis
Kirk is the founder and head trader at Option Alpha,
which offers an all-in-one platform for retail investors
and traders. Option Alpha is an industry leader in the
options trading space with first class education,
groundbreaking research, integrated backtesting, as
well as the first end-to-end automation technology for
options trading strategies.
Option Alpha and Kirk have been featured in dozens of publications

including Barron's, Smart Money, Forbes, Nasdaq, and MarketWatch.
The company was named to the #215 spot on the Inc. 500 in 2018 and
the #723 spot on the Inc. 5000 in 2019.
Kirk is a former Mergers and Acquisitions Investment Banking Analyst

for Deutsche Bank in New York, REIT Analyst for BB&T Capital Markets
in Washington D.C., and options strategy consultant for multiple funds,
family offices, and financial advisors. He holds a Bachelor’s degree in
Finance from the University of Virginia and lives in Pennsylvania with
his wife and three children.
Appendix & References
CBOE Option Strategy Indexes: http://www.cboe.com/products/strategy-benchmark-indexes
Options Basics Guide: https://www.optionseducation.org/strategies/all-strategies/covered-call-buy-write?prt=mx
TD Ameritrade Margin Handbook: https://www.tdameritrade.com/retail-en_us/resources/pdf/AMTD086.pdf
Pricing Table & Quote Screenshots: robinhood.com
Covered Calls Performance Research Report: https://optionalpha.com/covered-calls
Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized
Options (ODD). Copies of the ODD are available from your broker or from The Options Clearing Corporation, 125 S. Franklin Street, Suite 1200, Chicago, IL 60606. The
information ins this book is provided solely for general education and information purposes and therefore should not be considered complete, precise, or current. Many
of the matters discussed are subject to detailed rules, regulations, and statutory provisions which should be referred to for additional detail and are subject to changes
that may not be reflected in the book information. No statement within the book should be construed as a recommendation to buy or sell a security or to provide
investment advice. Past performance is not a guarantee of future returns.
The Cboe S&P 500 BuyWrite Index (BXMSM), Cboe S&P 500 2% OTM BuyWrite Index (BXYSM), Cboe S&P 500 95-110 Collar Index (CLLSM) and Cboe S&P 500
PutWrite Index (PUTSM) and other Cboe benchmark indexes (the “Indexes”) are designed to represent proposed hypothetical buy-write strategies. Like many passive
benchmarks, the Indexes do not take into account significant factors such as transaction costs and taxes. Transaction costs and taxes for a buy-write strategy could be
significantly higher than transaction costs for a passive strategy of buying-and-holding stocks. Investors attempting to replicate the Indexes should discuss with their
brokers possible timing and liquidity issues. Past performance does not guarantee future results. These materials contain comparisons, assertions, and conclusions
regarding the performance of indexes based on backtesting, i.e., calculations of how the indexes might have performed in the past if they had existed. Backtested
performance information is purely hypothetical and is provided in this document solely for informational purposes. Back-tested performance does not represent actual
performance and should not be interpreted as an indication of actual performance. The methodology of the Indexes is owned by Cboe Exchange, Inc. Supporting
documentation for statistics or other technical data is available by calling 1-888-OPTIONS, sending an e-mail to help@Cboe.com, or by visiting www.Cboe.com. Cboe®,
Cboe Volatility Index® Execute Success® and VIX® are registered trademarks and BXM, BXR, BXY, CLL, PUT, BXMD, CMBO, BFLY, CNDR, CLLZ and PPUT are service
marks of Cboe Exchange, Inc. Standard & Poor's®, S&P®, S&P 100®, S&P 500®, Standard & Poor's 500®, SPDR®, Standard & Poor's Depositary Receipts®, Standard & Poor's
500, 500, Standard & Poor's 100, 100, Standard & Poor's SmallCap 600, S&P SmallCap 600, S&P 500 Dividend Index, Standard & Poor's Super Composite 1500, S&P
Super Composite 1500, Standard & Poor's 1500 and S&P 1500 are trade names or trademarks of Standard & Poor's Financial Services, LLC. Any products that have the
S&P Index or Indexes as their underlying interest are not sponsored, endorsed, sold or promoted by S&P OPCO LLC ("Standard & Poor's") or Cboe and neither Standard
& Poor's nor Cboe make any representations or recommendations concerning the advisability of investing in products that have S&P indexes as their underlying
interests.

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Letter from Kirk

We are taught by traditional media, schooling, and decades of

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The last major greek is Theta. Theta is the decay of an

As expiration approaches, Theta speeds up, and the

Alright - Whew! That was a lot of basics to cover, and

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Who Can Trade Covered Calls?

own if you choose to do so. You'll also hear this

The best way to think about a covered call, in our view,

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Well, our research team set out on a new mission and

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For clarity, each strike price doesn't need to have

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Admittedly, it’s not as bad as GOOD on the previous

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Factor #2 - Fundamental or Technical Analysis Filters

Filters for fundamental or technical analysis could

Now, you're a pretty smart person if you're reading

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When it comes to implied volatility, the roles are

A call option 90 days from expiration will witness its

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So how far out in time should you sell covered calls?

Step 3: Choose the Call Option Strike Price

Deciding the final strike price for selling a covered call

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SPX BXMD BXM

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Which one do you pick? Tough question for sure.

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If you sell the front-month options, you will collect a

If you've followed the first three steps outlined in this

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