Ready to dive into the world of options trading and potentially generate some income from your existing stock holdings? Writing covered calls can be a fantastic strategy for that, and Merrill Edge provides the tools to do it. This comprehensive guide will walk you through everything you need to know, step-by-step.
The Power of Covered Calls: An Introduction
A covered call is an options strategy where you own shares of a stock (the "covered" part) and then sell call options on those same shares. The goal is to generate income from the premium you receive when selling the call option. It's often used when you believe the stock's price will remain relatively stable or experience only a modest increase in the short to medium term.
Think of it this way: you're essentially agreeing to sell your shares at a specific price (the strike price) by a certain date (the expiration date), in exchange for an immediate payment (the premium). If the stock stays below the strike price, you keep the premium and your shares. If it goes above, your shares might be "called away" (sold) at the strike price.
Ready to learn how to implement this on Merrill Edge? Let's begin!
A Step-by-Step Guide to Writing a Covered Call on Merrill Edge
Before you even log in, there are a few prerequisites and considerations.
Step 1: Laying the Groundwork – Are You Ready for Options Trading?
This is where you come in! Before we jump into the Merrill Edge platform, let's ensure you're prepared.
Sub-heading: Do You Have the Right Account and Approval?
Merrill Edge Account: You'll need an active Merrill Edge Self-Directed brokerage account. If you don't have one, you'll need to open one first.
Options Trading Approval: Trading options requires a special approval level from Merrill Edge due to the inherent risks. If you haven't traded options before, you'll need to apply for options trading privileges. This usually involves answering questions about your financial situation, investment experience, and risk tolerance. Merrill Edge typically has different "options levels," with covered calls often falling under a lower, more basic level of approval. Ensure your account is approved for at least Level 1 options trading.
Sub-heading: Do You Own the Underlying Stock?
A covered call, by definition, means you already own the shares you're selling calls against.
You need to own at least 100 shares of the specific stock for every one options contract you plan to sell. (Each options contract represents 100 shares).
Sub-heading: Understanding Your Outlook on the Stock
Neutral to Slightly Bullish: Covered calls are best suited for stocks you expect to remain relatively flat or experience only a slight increase in price.
Willing to Sell at the Strike Price: You should be comfortable with the possibility of your shares being "called away" at the strike price if the stock rises above it. If you're highly bullish on a stock and believe it will surge significantly, a covered call might limit your upside potential.
Step 2: Logging In and Navigating to the Options Chain
Alright, let's get hands-on!
Log in to Merrill Edge: Go to the Merrill Edge website and log in to your self-directed brokerage account.
Locate Your Stock: Once logged in, navigate to your portfolio or use the search bar to find the stock you intend to write the covered call on.
Access the Options Chain: Look for a tab or link associated with the stock that says "Options," "Options Chain," or "Trade Options." Clicking this will display the options contracts available for that particular stock.
Step 3: Selecting Your Covered Call Parameters
This is where you make key decisions about your covered call.
Sub-heading: Choosing an Expiration Date
Time Horizon: The expiration date is when the option contract expires. Common expirations range from weekly to several months out.
Consider your outlook: If you expect the stock to stay flat for a short period, a nearer-term expiration might be suitable. If you want to collect premium over a longer period, a further-out expiration is an option. Shorter-term options generally have less premium but also less time for the stock to move significantly against you.
Sub-heading: Selecting a Strike Price
Out-of-the-Money (OTM) vs. At-the-Money (ATM) vs. In-the-Money (ITM):
Out-of-the-Money (OTM): The strike price is above the current stock price. This is generally preferred for covered calls as it allows for some upward movement in the stock before your shares are at risk of being called away. You receive a smaller premium, but your shares are safer from being assigned.
At-the-Money (ATM): The strike price is equal to the current stock price. You'll receive more premium than an OTM call, but there's a higher chance of your shares being called away if the stock moves up even slightly.
In-the-Money (ITM): The strike price is below the current stock price. You'll receive the highest premium, but your shares are highly likely to be called away, and you'll miss out on any appreciation between the current price and the strike price. This is usually chosen if you are prepared to sell the stock at the strike price.
Strategic Choice: Most investors selling covered calls aim for out-of-the-money (OTM) calls to balance income generation with the desire to hold onto their shares.
Sub-heading: Analyzing the Premium
The premium is the amount of money you receive for selling the option contract. This will be displayed in the options chain. It's quoted per share, so if the premium is $1.50, you'll receive $150 for one contract (100 shares x $1.50).
Higher premiums usually come with strike prices closer to the current stock price or with longer expiration dates.
Step 4: Placing Your Order – "Sell to Open"
Once you've chosen your desired expiration date and strike price, it's time to create the order.
Identify the "Sell" Side: In the options chain, locate the chosen call option. You'll see "Bid" and "Ask" prices. As a seller, you'll be looking at the Bid price (what buyers are willing to pay).
Select "Sell to Open": This is crucial. You are opening a new short position in the call option. Do not select "Buy to Open" or "Sell to Close."
Specify Quantity: Enter the number of contracts you want to sell. Remember, 1 contract = 100 shares. If you own 500 shares, you can sell up to 5 contracts.
Choose Order Type:
Limit Order (Recommended): This allows you to specify the exact premium you want to receive. Your order will only execute if that price (or better) is met. This gives you more control.
Market Order (Use with Caution): This executes immediately at the best available price. While quick, the price can fluctuate rapidly, potentially giving you a less favorable premium.
Review Your Order: Merrill Edge will typically provide a summary of your order, including the stock symbol, call option details (strike, expiration), quantity, and the estimated credit (premium) you'll receive. Double-check everything carefully before proceeding.
Confirm and Place Order: If everything looks correct, confirm and place your order.
Step 5: Monitoring Your Covered Call Position
Once your order is filled, you've successfully written a covered call! Now, it's about monitoring and managing the position.
Portfolio View: Your Merrill Edge portfolio will now show your long stock position and your short call option position.
Track Stock Price: Keep an eye on the underlying stock's price relative to your strike price.
If the stock stays below the strike price, the option will likely expire worthless, and you keep the entire premium.
If the stock rises above the strike price, there's a higher chance of your shares being "called away" (assigned).
Time Decay (Theta): Options lose value as they get closer to expiration. This "time decay" works in your favor as a seller, as the option you sold will naturally decline in value over time (assuming the stock price remains stable).
Sub-heading: Managing Your Covered Call Before Expiration
Buy to Close: If the stock drops significantly or you simply want to close the position and keep your shares (and the premium collected so far), you can "buy to close" the option. This means you buy back the same option contract you sold. If the option's value has decreased, you'll buy it back for less than you sold it for, locking in a profit.
Roll the Option: If the stock is approaching or has gone above your strike price, but you don't want your shares called away, you might consider "rolling" the option. This involves:
Buying back your current short call to close it.
Selling a new call with a later expiration date and/or a higher strike price.
Rolling typically aims to bring in more premium and/or give the stock more room to run before assignment.
Step 6: Handling Expiration and Assignment
As the expiration date approaches, one of two main scenarios will occur:
Sub-heading: Option Expires Worthless
Scenario: The stock price remains below your strike price at expiration.
Outcome: The call option expires worthless. You keep the entire premium you collected when you sold the option, and you retain ownership of your 100 shares of stock. Congratulations, you've generated income!
Sub-heading: Option is Exercised (Shares Called Away)
Scenario: The stock price is above your strike price at expiration.
Outcome: The buyer of the call option will likely "exercise" their right to buy your shares at the strike price. Your 100 shares of stock will be automatically sold at the strike price.
Profit Calculation: Your profit in this scenario is the premium received plus any appreciation of the stock up to the strike price. Remember, your upside profit is capped at the strike price.
Important Considerations and Risks
While covered calls can be a great income-generating strategy, it's vital to understand the risks:
Limited Upside Potential: If the stock skyrockets, your profit is capped at the strike price plus the premium received. You miss out on any gains above that level.
No Downside Protection (Beyond Premium): The premium you receive offers only limited protection against a decline in the stock's price. If the stock plummets, you're still exposed to significant losses on your underlying shares, beyond the small offset of the premium.
Assignment Risk: Your shares can be called away at any time before expiration if the option is in-the-money (especially American-style options). This is particularly relevant around dividend dates.
Transaction Costs: While Merrill Edge offers $0 commissions for online stock, ETF, and options trades, there's a $0.65 per contract fee for options. Keep these fees in mind when calculating your potential profit.
Frequently Asked Questions (FAQs)
Here are 10 related FAQ questions to help solidify your understanding:
How to get approved for options trading on Merrill Edge?
You'll need to navigate to the "Accounts" or "Profile" section of your Merrill Edge account and look for an "Options Trading Application" or similar link. This typically involves completing a questionnaire about your financial situation, investment experience, and risk tolerance.
How to choose the right stock for a covered call?
Look for stocks you already own, are comfortable holding long-term, and believe will trade sideways or experience a modest increase. Avoid highly volatile stocks if income generation is your primary goal.
How to determine the best strike price for a covered call?
Consider your outlook on the stock. If you want to keep your shares, choose an out-of-the-money (OTM) strike price. If you're willing to sell the stock at a certain price, an at-the-money (ATM) or slightly in-the-money (ITM) strike might be suitable for higher premium.
How to select the optimal expiration date for a covered call?
Shorter-term expirations (e.g., weekly or monthly) offer less premium but quicker cycles. Longer-term expirations offer more premium but tie up your shares for longer and expose you to more time for significant price movements. Match the expiration to your market outlook.
How to calculate the maximum profit of a covered call?
Maximum profit = (Strike Price - Original Stock Purchase Price) + Premium Received. If your stock is purchased at $100, you sell a $105 call for $2 premium, your max profit is ($105 - $100) + $2 = $7 per share, or $700 per contract.
How to calculate the breakeven point for a covered call?
Breakeven point = Original Stock Purchase Price - Premium Received. If you bought stock at $100 and sold a call for $2 premium, your breakeven is $100 - $2 = $98 per share.
How to roll a covered call on Merrill Edge?
To roll a covered call, you first "buy to close" your existing short call option, and then simultaneously "sell to open" a new call option with a different (typically later) expiration date and/or strike price. Merrill Edge's platform often has a dedicated "Roll" function for this.
How to avoid early assignment with covered calls?
While you can't guarantee avoiding early assignment, it's less likely for out-of-the-money (OTM) calls. Be particularly aware of ex-dividend dates, as in-the-money (ITM) calls often get exercised before dividends are paid.
How to manage a losing covered call position?
If the stock drops significantly, the covered call itself hasn't caused the loss, but the value of your underlying shares has decreased. You can let the option expire worthless (keeping the premium) or buy to close it if you anticipate a rebound.
How to find suitable stocks for covered calls on Merrill Edge?
Utilize Merrill Edge's research tools and screeners. Look for stable, dividend-paying stocks with moderate volatility that you already hold or are considering adding to your long-term portfolio.
