How to Construct a Profitable Covered Short Call Position
In this article, we will introduce a trading strategy that will allow you to build a passive income when the markets are going down or will guarantee you a profitable trade when markets are going up. There are several strategies to do this, however, a very simple one is to engage in a covered short call position.
First, what is a short call?
A short call is a contract with another person where you become obliged to sell your asset at a certain price on a given date. There are European calls and American calls. The only difference between them is that with European calls you are only able to execute your call options on the date of expiration, whereas American calls you can also choose the time between the day you engage in the option until the expiry date.
Now, how can we use a short call to make money over time?
In this article we will use Royal Dutch Shell (Ticker Symbol: RDSA) to make hypothetical scenarios, as one should when trading. We will explain a scenario if the stock will go up, and a scenario if the stock will go down.
Starting the simple scenario, we will assume that the stock Royal Dutch Shell will go up in value over time. However, we want to minimize our risk of trading the stock. At the current time of writing (September 25th), the stock is €26.40. We will need to buy 100 stocks, or 1 lot, in order to engage in a short call option. This is because the 1 option call is a bundle of 100 stocks.
Then imagine we can see the call prices with their respective premiums. We could sell a 18OCT2019 call @27.00 with a premium of 0.19/share. This would mean that we will get €19 today as a premium to be obliged to sell if the call buyer wants to execute the option. Assuming the stock goes to €28.00 on the 18th of October, the call buyer will execute the option in order to make money. However, we will be selling our shares at €27.00, which is still above our ABP, Average Buy Price, therefore realizing a profit of around €0.80/share (excluding transaction costs).
The other scenario would be that the stock will go down over time. Here we also assume we buy today at €26.40 per share and engage in the 18OCT2019 call @27.00 with a current premium of 0.19/share. Assuming the stock will go down to €25.00, we will make a loss with our RDSA position. However, we would have collected €19 in premium fees from the short call, which would reduce the % loss on the overall position. The benefit would also be that you keep your 100 shares and can still engage in another covered short call trade for the next month.
Through this process, you will be able to collect passive income over time. Royal Dutch Shell also gives a dividend to shareholders every 3 months, which can also be considered as passive income. At the end of the day we will be generating passive income when the markets fall and make money when the markets go up.