This Covered Call Strategy Has a 100% Chance of Profit

Investing in stocks can be a dynamic and profitable endeavor, but the risk of loss can discourage many investors. One strategy that helps to mitigate this risk while potentially enhancing returns is the covered call. This article will explore how to set up a covered call trade with an almost guaranteed profit scenario, offering a practical and conservative approach to generating income from existing stock investments.

What is a Covered Call?

A covered call is an options trading strategy that involves holding a long position in an underlying stock and simultaneously selling a call option on the same stock. This strategy is primarily used to generate an income stream from the option premiums, which the investor collects when selling the call options.

The Mechanics of a Covered Call

To execute a covered call, you need to:

1. Own or Purchase Shares: Typically, each options contract is for 100 shares of the underlying stock. Ensure you own at least 100 shares of the stock you intend to use in the covered call.
2. Sell Call Options: For every 100 shares you own, you can sell one call option. The choice of which call option to sell depends on your strike price preference and expiration date.

Choosing the Right Stock

The success of a covered call strategy heavily depends on the stock selection. Ideal characteristics include:

• Stability: Stocks with less price volatility are preferred as they pose lower risks of significant price drops.
• Dividends: Stocks that pay dividends offer additional returns on your investment, compounding the income earned from selling calls.

Selecting the Strike Price

The strike price is the price at which the call option can be exercised by the buyer. For a nearly foolproof profit scenario, consider:

• In-the-Money (ITM) Calls: Selling an ITM call where the strike price is below the current stock price increases the probability of the stock being called away. However, it provides higher premium income and greater downside protection in case the stock price decreases.
• At-the-Money (ATM) Calls: These calls have a strike price very close to the current stock price, offering a balance between premium income and retaining some upward price potential.

Setting the Expiration Date

The expiration date of the call option is crucial in managing how long your stock is tied up in the covered call setup. Shorter expiration periods:

• Generate Income More Frequently: Allows you to write new calls more often, potentially increasing annual income.
• Reduce Exposure: Limits the time your stock could drop significantly without the option to sell it freely.

Calculating Guaranteed Profits

To set up a covered call with a 100% chance of profiting, focus on the premium collected from selling the option. Here’s a straightforward example using American Eagle Outfitters (AEO):

1. Stock Purchase Price: Assume you bought 100 shares of AEO at $20 per share, totaling $2,000.
2. Selling an ITM Call: You sell one call option with a strike price of $18, which is currently trading with a premium of $3.00 per share. The total premium collected is $300 (100 shares x $3.00).
3. Profit Calculation: If AEO’s stock price stays above $18 by expiration, the shares are likely to be called away. You receive $1,800 from the sale of the stock ($18 x 100 shares) plus $300 from the premium, totaling $2,100. This results in a net profit of $100, notwithstanding a potential drop in the stock price to the strike price.

Risk Considerations

While covered calls are generally considered a lower-risk strategy, they are not without risks. The main risk is opportunity cost. If the stock price rises well above the strike price, you miss out on potential gains above the strike price as the buyer of the call will likely exercise their option.