Covered calls are one of the most common strategies for an option trader. They are simple in concept, but they can also be as complex as you want them to be. When completed, they can greatly reduce the risk involved when you are long the market with a futures contract.

In simple terms what you are going to do is buy a futures contract and then sell a Call at a strike price above where you entered the market on the futures contract. For example, long the futures from 10 and sell a Call at 12 and collect the premium for selling the Call.

Before you put on a covered Call you need to be bullish to neutral on the market you are trading. There are several ways to look at why you would do a Covered Call, but they all boil down to reducing risk and/or increasing profits on the long futures contract. Sounds like the best of both worlds, doesn’t it? Well, sometimes it is and sometimes it isn’t.

Many times, a Covered Call will allow you to enter a trade that you might not otherwise make. Look at figure 5.1.

As you can see, the Risk/Reward is 2:1 but the Risk in dollars is $1,500 or 15% of our trading account ($10,000 account). But we should only be risking 5% of our account on any one trade, in this case $500, right? So.... Options to the rescue!

What would happen if we sold a Call Option near our exit target? Of course, when we sell the option, we collect the premium and it goes into our account. Look at figure 5.2. A 535 Call is selling for 10 points or $1,000. It’s just below our target of 540.80 but I’d be willing to give a little to get a lot. Wouldn’t you? But sometimes, using options you don’t have to give up anything to get an advantage on the trade.

So, David, what would I actually get by doing this? Glad you asked! You get $1,000 in premium (money paid to you) added to your account. But it gets better. Now before you read any further go back and look at the chart (figure 5.1) again and think. What are the ramifications of selling a Call vs. the benefits? Ask yourself what happens if the price does go up and hits my target? What happens if the price comes down and stops me out? Would I be better off doing something else? If so, what else could I do? Come on now and do this little exercise. You must learn to think these trades through on your own.

Well, what did you come up with? Would you sell the Call or just not make the trade at all?

These are the only four things that could happen. So, let’s look at each one and then break it down and see what would happen in each scenario.

1. Price could move lower: If this happens and the market drops $1,500 you get stopped out with a loss of $1,500. But, and it’s a big but, the call you sold will also lose value (go down in price) and the amount it goes down is profit to you. You could exit the trade at this point and let’s say the option went down to $500 and you bought it back then you get to keep the difference between what you sold it for, $1,000, and what you bought it back for $500. So you just lowered your risk $500. And if the price kept coming down you might decide to just keep the Call, exiting the futures contract and let it expire worthless (anything below 535.00 at expiration) and keep the entire premium.

2. Price could remain stable and go sideways: If this happens you could still profit on the trade. Why? Because unless you lose more than $1,000 on the futures contract, you made money because you get to keep the $1,000 premium on the Call option you sold.

3. Price can move higher but not above 535.00: If the price does not go above 535.00 by the options expiration date then you keep the entire $1,000 in premium on the Call Option you sold. And if the price is above your entry point on the futures contract, then you will also make money on the futures side as well. In other words, you made money on the Call AND the Futures contract.

4. Price can move higher and go above the 535 strike price: Even if the price goes above 535.00 we are still protected because we are making money on the futures contract at the same time we are losing money on the option. And at expiration, we will always make the difference between our entry point in the futures market and the options strike price. So in this case even if the price went to 700.00 we win and get to keep the option premium.

This might be a little confusing, so let me give you a simple example. Let’s say you are long Sugar from 15.00 and you sell an 18.00 Call option. Then let’s say that Sugar goes to 20.00. So at expiration you lost 2.00 on the Sugar Call Option you sold 20-18=2 but you made 5.00 on the futures contract 20-15=5. The bottom line is you made 5 cents on the futures, lost 2.00 cents on the option for a net gain of 3.00 cents on the trade which is exactly the difference between where you entered the market on a futures contract (15) and the strike price (18) of the option you sold.

Let’s look at figure 5.3 and see what happened in the Gold trade. Look at the chart and you can see the price did go up as expected and hit our profit target. The net effect of this trade is that we made $3,000 on the futures contract but we had to buy the Call option back for $2,200 resulting in a $1,200 loss on the option.

So we made a net profit (before commissions) of $1,800. I can just hear you now saying David this did not make sense to do this trade because if we had just stuck with the futures and not done a covered call then we would have made $3,000, not $1,800. That’s partially correct. We would have made more on the futures contract without the Call option but let’s think this through before calling me insane!

Now, it’s time to put that thinking cap back on again.

Okay, I know you hate doing this but THINK! Why did it make more sense to do a covered Call than a straight futures contract?

Got it yet? Sure you do. To start with the Risk/Reward ratio was out of line for a straight futures contract and we would have had to risk 15% of our account on a single trade; something that should never be done. But there is another reason. Have you figured it out yet? It’s that by doing the Covered Call we had a lower risk-reward ratio. Our risk of $1,500 on the futures contract was offset by $1,000 on the Call we sold! So if we really only had $500 at risk on the trade and made $1,800 then we made a 3:6 return for dollars risk! Much better than the 2:1 return on the futures contract would have given us and we still only had to risk 5% of our account. READ THAT AGAIN!

You must start looking at what your rate of return is per dollar put at risk and stop looking at the trade as if you could have made more money on a futures contract without an option. I’m even going to show you later on in the course how you can make more on options than you could on futures alone. Getting excited yet? I hope so because I’m getting excited even telling you about it.

And while I’m thinking about it, you don’t have any margin on the Call you sold because any losses on it will be offset by the gain in the futures price. In other words, your losses (if any) on the option are more than made up by the gains you are making on the futures contract if the price goes up. Of course, you will still have to put up the margin on the futures contract but the $1,000 in premiums you collect goes directly into your account and you can use it to place other trades, etc. It really is a win-win situation and can be used on almost any futures trade you do.

Also, you can keep the futures contract if you think the market is still going to make a big move and close out the option by offsetting it. This of course leaves you long the market on the futures side of things with unlimited profits. (Be sure to use stops of course)

Another option (pun intended) is to put a covered call on after you are already long the market in a futures trade. Maybe you see some resistance coming up and are looking for the market to bounce off this resistance and come back down. If it does, you want to protect some of your profits on the futures contract. See Figure 5.4.

In this example, we have the best of both worlds. We are up $2,180 on the futures contract but the price is almost at a prior resistance level. We would like to stay in the trade because it doesn’t look like very strong resistance yet and the indicators haven’t turned bearish yet. But if the market does come back down, even if it’s just a temporary pullback we want to protect our profits of $2,180 on the futures side.

How do we do this? Glad you ask! We sell a Call just above the major resistance from the monthly chart and collect the premium of $830.00. This way if the price does come back down then the Call loses value and we are protecting some of our profits on the futures contract that is losing money. If the price goes up and breaks past the first resistance, then we will continue to make more money on the futures contract than we are losing on the Call option we sold.

Remember, the futures contracts always make more money for us (until the option is deep-in-the-money) than we will lose on the option we sell because the option doesn’t increase in value at the same rate. And when the option does get deep into the money and goes up dollar for dollar with the futures contract then we are making exactly the same on the futures contract that we lose on the option. In other words, when the option goes deep-in-the-money and we are long a futures contract and sold a call if we lost $500 on the option, we also made $500 on the futures contract so we could stay in the trade until expiration without further risk of loss on the option we sold.

Now if you aren’t grasping this yet, then stop right now and go back over it and open your own TNT software and paper trade some of these scenarios yourself.