The Basics Of Covered Calls

By Daniel Myers AAA

Widely viewed as a conservative strategy, professional investors write covered calls to increase their investment income. But individual investors can also benefit from this simple, effective option strategy by taking the time to learn it. By doing so, investors will add to their investment arsenal and give themselves more investment opportunities. Let's take a look at the covered call and examine ways that you can use it in your portfolio.

TUTORIAL: Option Spread Strategies

What is a Covered Call?
As a stock owner, you are entitled to several rights. One of these is the right to sell your stock at any time for the market price. Covered call writing is simply the selling of this right to someone else in exchange for cash paid today. This means that you give the buyer of the option the right to buy your shares before the option expires, and at a predetermined price, called the strike price. (For more, see Cut Down Option Risk With Covered Calls.)

A call option is a contract that gives the buyer of the option the legal right (but not the obligation) to buy 100 shares of the underlying stock at the strike price any time before the expiration date. If the seller of the call option owns the underlying shares the option is considered "covered" because of the ability to deliver the shares without purchasing them in the open market at unknown - and possibly higher - future prices.

Profiting from Covered Calls
For the right to buy shares at a predetermined price in the future, the buyer pays the seller of the call option a premium. The premium is a cash fee paid to the seller by the buyer on the day the option is sold. It is the seller's money to keep, regardless of whether the option is exercised.

When to Sell a Covered Call
If you sell a covered call, you get money today in exchange for some of your stock's future upside.

For example, let's assume you pay $50 per share for your stock and think that it will rise to $60 within one year. Also, you'd be willing to sell at $55 within six months, knowing you were giving up further upside, but making a nice short-term profit. In this scenario, selling a covered call on your stock position might be an attractive option for you.

After looking at the stock's option chain, you find a $55, six-month call option selling for $4 per share. You could sell the $55 call option against your shares, which you purchased at $50 and hoped to sell at $60 within a year. If you did this, you would obligate yourself to sell the shares at $55 within the next six months if the price rose to this amount. You would still get to keep your $4 in premiums plus the $55 from the sale of your shares, for the grand total of $59 (an 18% return) over six months.

On the other hand, if the stock falls to $40, for instance, you'll have a $10 loss on your original position. However, because you get to keep the $4 option premium from the sale of the call option, the total loss is $6 per share and not $10.

Scenario No. 1: Shares rise to $60, and the option is exercised
January 1 Buy XYZ shares at $50
January 1 Sell XYZ call option for $4 today
Expires on June 30, exercisable at $55
June 30 Stock ends at $60; option is exercised because it is above $55. You receive $55 for your shares.
July 1 Total Profit: $5 (capital gain in the stock) + $4 (premium collected from sale of the option) = $9 per share, or 18%
Scenario No. 2: Shares drop to $40, and the option is not exercised
January 1 Buy XYZ shares at $50
January 1 Sell XYZ call option for $4 today
Expires on June 30, exercisable at $55
June 30 Stock ends at $40; option is not exercised and it expires worthless because stock is below strike price. (After all, why would the option buyer want to pay $55/share when he or she can purchase the stock in the market at the current price of $40?)
July 1 Total Loss: -$10 + $4.00 = -$6.00, or -12%. You can sell your shares for $40 today, but you still keep the option premium.

Covered Call Advantages
Selling covered call options can help offset downside risk or add to upside return, but it also means you trade the cash you get today from the option premium for any upside gains beyond $59 per share over the next six months, including $4 in premiums. In other words, if the stock ends above $59, then you come out worse than if you had simply held the stock. However, if the stock ends the six-month period anywhere below $59 per share, then you come out ahead of where you would've been if you hadn't sold the covered call.

Covered Call Risks
As long as you have the short option position, you have to hold onto the shares, otherwise you will be holding a naked call, which has theoretically unlimited loss potential should the stock rise. Therefore, if you want to sell your shares before expiration, you must buy back the option position, which will cost you extra money and some of your profit.

Summary
You can use covered calls as a way to decrease your cost basis or to gain income from your shares, even if the stock itself doesn't pay a dividend. As such, this strategy can serve you as an additional way to profit from stock ownership. As options have risk, be sure to study all of your choices, as well as their pros and cons, before making a decision. For additional reading, see An Alternative Covered Call Options Trading Strategy and Using LEAPS In A Covered Call Write.

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