Sunday, November 21, 2021

Covered Calls for Beginners

Along with putting together a rock-solid dividend portfolio, another aspect that was appealing was generating additional returns from covered calls and puts. To help with understanding, I purchased a copy of Covered Calls for Beginners by Freeman Publications.

My experience with options was fairly limited to watching people on Wall Street Bets make absolute killings or get killed. Since I'm fairly risk averse, I have no desire to commit to risky bets. 

This book is a great introduction into the world of covered calls. While there is some inherent risk to selling covered calls, I like that the risk can be managed effectively. Some of my takeaways from the book:
  • Since I'm building a portfolio of high-quality assets, the volatility risk for Home Depot is less than something like a Tesla.
  • Understand the greeks:
    • Delta is how much the option's price changes vs. change in the security. It can also be used as a proxy for the probability of being in the money at expiration.
    • Gamma can be used to measure the stability of delta. Higher gamma represents higher risk. 
    • Theta measures the time decay. As an option gets closer to the expiration date, the rate of theta accelerates.
  • Where this book was VERY helpful is understanding the rate of return on covered calls. I've put together a spreadsheet to help calculate the annualized options yield before I make these decisions.
    • This was more helpful than I realized. What I've learned over the last month is that since I'm writing covered calls on less volatile securities, the premiums are relatively small. Since I've been conditioned on options being big winners or losers, I have a bias when looking at those small returns and dismissing it. Now that I can analyze the annualized return before taking a position and see the benefit of an additional 8-20% return.
  • Understanding exit strategies!
    • Obviously we want our covered call options expiring out of the money so we can keep the full premium. Some of the bloggers I follow that employ similar strategies roll over their options, so when should I do that?
      • One Percent Rule - If the value of the option is worth less than 1% of the security, sell and rewrite.
      • 2 & 20 Rule - If in the first two weeks you can buy back your option for <20% of what you paid, then buy it back and rewrite.
        • Looking at my current covered calls, I wrote 1 contract for LEG a $45 strike price 12/17 expiration earlier last week. Cost basis was $1.19 a share. Today, it's worth $0.225 a share. Based on the above rule I take the profit and rewrite.
Overall this is a good book to start feeling comfortable with covered calls. I've also done some research online and I've found the site Option Strat is superb for helping understand various options strategies and the associated risks. 

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