The Covered Call Stock Option Strategy

Posted on admin No Comments

A popular stock option strategy used by investors is the covered call. The covered call is one in which you would write a call option contract for a number of shares of stock you actually own. If you own the stock before writing the call option it is called an overwrite. If you buy the stock as you create the call contract, it is called a buy-write.

 

The stock you own is covering the call option contract which is where the name is derived from. This stock option strategy is generally used when the market is going sideways or you form an opinion that a bull market is developing.

 

With the covered option, the price for the underlying asset has been determined already unlike in a naked option where you don’t own the stock. When the option is uncovered, you will have to go to the market to buy the stock if and when it becomes necessary to cover the option. It is possible to cover your option at any time before the expiration date of the option contract.

 

The covered call stock option strategy is less risky than the uncovered option simply because you already know the price of the underlying asset. The covered call is used to generate income from the underlying asset or stock.

 

You get to keep the premium on the covered call and if the contract expires then you also profit from any gains in the stock value. If the option is exercised you will earn the premium in addition to the difference between the purchased stock price and the strike price. This stock option strategy can also protect you from underlying stock that that may experience a price decline.

 

The breakeven point for the covered call stock option strategy is equal to the stock purchase price less the premium received.

What Is a Covered Call Option Explained – Selling & Writing Strategies

Posted on admin No Comments

What Are Call Options?

 

Before we can discuss how to write covered calls, we need to first understand what a call option is. A single call option contract is an agreement that allows the buyer to purchase 100 shares by a specified expiration date at a certain strike price. These contracts can be both “purchased” and “written” depending on where one sees the company’s stock price going. The value of the contract will be based, in part, on the following:

 

How volatile the stock has been in the past

Anticipated or expected future price volatility

Amount of time until contract expiration

 

Types of Call Options

 

There are two types of call options: naked and covered. To understand covered calls, you need to first understand naked options.

 

1. Naked Call Options

 

In a naked call option, you write call options contracts without owning the underlying shares. While your bets might pay off, you could lose a lot of money too.

 

If you are writing naked call options, you think there is a chance a company’s stock price may fall. As the options writer, you have the flexibility to set the strike price and expiration date. If someone buys your options, he has purchased the right to acquire the stock from you at the predetermined strike price before the expiration date. This person has acquired your options since he believes the company’s stock price will rise before the expiration, and therefore wants to lock in a lower price. In effect, by writing a naked call option, you are betting that the company’s stock price will fall while the buyer is betting that the stock price will rise. It is simply two people speculating on share price direction.

 

The major risk involved with writing a naked call option is in the event that the stock rises in price. In this case, when the purchaser of the options exercises his options, you are forced to acquire the physical stock at the current price and sell these to the option holder at the predetermined lower price. You will be stuck with a loss, which sometimes can become crippling to your portfolio depending on how high the stock has risen.

 

How can one avoid this unlimited downside? By writing call options while also owning the underlying shares, known as a covered call, you can create numerous strategies that can net you significant income while limiting your potential losses.

 

2. Covered Call Options

 

In a covered call strategy, not only would you write call options, but you would also own the actual stock for which you are writing the options. Thus, if the stock price rises, while you would still be liable to provide the option holder with the physical shares, you can simply provide the option holder with the stock in your portfolio instead of being forced to buy the stock on the open market at the new, higher price. You have effectively eliminated the major risk that comes with a naked option.

 

Is the Covered Call Option Right for You?

 

Generally, a covered call strategy is ideal for someone who is bullish on a company’s stock price and therefore has acquired a substantial amount of shares, but also wants to create an additional income stream that will lower his net cost of shares and possibly protect him against a loss in share prices. By writing call options, the downside risk has been reduced, although the upside is also capped. Thus, if the stock price does indeed fall, the investor will lose money on his actual shares, but this will be offset by the income derived from selling call options (which presumably will not be exercised). Selling covered calls has the potential to be more profitable than simply holding shares if share prices fall, stay the same, or rise mildly. The only time that share investing will be more profitable than covered call trading is when there is a significant rise in share prices.

 

Covered Call Example

 

This is a simple example of how to employ the covered call strategy. You own 100 shares of Google (NASDAQ: GOOG). The share price is $550. You sell one 6-month long call option contract for $33.21 per share at a $550 strike price to protect you from a potential decrease in Google’s stock price.

At the end of those 6 months, the following may be true:

 

Share prices of Google are $550 or above. If the options are exercised, you must sell your shares for exactly $550 per share. You will have made a 6% return in 6 months from the $33.21 per share of income. Your break-even point is if Google is trading at $583.21 ($550 + $33.21 per share options premium); that is, you would have made the exact same amount of profit if you had simply held your shares and not written the call options. If Google is between $550 and $583.21, then you made a wise investment decision by writing the call options. If Google ends up higher than $583.21, you would have been better off not writing the options. Therefore, if you strongly feel that share prices will go higher than $583.21 in 6 months, you may want to simply hold the shares. But if you expect share prices to be neutral or have very mild gains, then selling call options is a great way to create income revenue as a replacement for the anticipated lack of capital gains.

 

Share prices are less than $550. In this case, the options will not be exercised and you will keep both your shares and the income from selling options. The $33.21 per share will help offset your share price loss. Your break-even point is if Google is trading at $516.79 ($550-$33.21). If Google trades above this point, you will have made a profit; if it trades below, you will have suffered a loss. Effectively, even one penny below this break-even point is where you would have been better off selling your 100 shares at $550 instead of holding them and writing the call options.

 

The big advantage for covered call writing as opposed to simple stock investing is an immediate 6% income payout regardless of how share prices perform. In this instance, the combination of options revenue plus share price movement means we are profitable even if stock prices fall up to 6%. The only time that holding shares is more advantageous than the covered call strategy is if share prices rise more than 6% in 6 months, which is certainly possible (but even in this case, you still will have made 6%).

 

Of course, the one other large downside is that we are forced to hold our shares until the options contract expires, or alternatively buy back the contract prior to expiration. This limiting factor should be taken into consideration as well.

Covered Call Strategies

 

Below are a few quick strategies you can use with covered calls. Some apply to blue chips stocks, others to high-risk companies, and some for those stocks for which you expect minimal gains.

 

1. Boosting Dividends

 

Buying shares and selling options contracts lowers your effective cost basis. In addition, you will still collect 100% of the dividends from companies who provide these payments. As a result, selling options contracts will increase your dividend yield. Below is an example:

 

You acquire Nutrisystem (NASDAQ: NTRI) shares, which provide quarterly dividends at $0.175 per share, at the current price of $14.24.

You then sell call options that expire in 9 months with a strike price of $10 per share that are valued at $4.50.

You receive an instant return of $4.50, which lowers your net cost per share to $9.74.

 

As explained above, share prices can fall almost 32%, from $14.24 to your net cost of $9.74, without any capital loss being incurred.

In addition, at your new cost basis of $9.74 per share, your annual dividend yield rises from 5% to 7.2%. Thus, while you have limited your capital gain upside, you have also significantly increased your dividend yield. This is an especially good strategy if you don’t think the underlying stock price will make large gains, or if you are very averse to risk and want to profit largely from dividends while creating a 32% hedge against falling share prices.

 

2. Adding Income Stream to Capital Gains

 

Another way to play covered calls is to set the strike price above the current price. You would do this if you expect share prices to appreciate moderately. By doing so, you profit from both a rise in share prices and the extra revenue from selling the options. Below is an example:

 

You anticipate that shares of Ford (NYSE: F), which currently trades at $15.28, will go up over the next 3 months.

You own shares at $15.28 each.

You sell a call options contract for $0.29 per share that will expire in 3 months with a strike price of $17 per share.

 

If share prices rise, you are allowed to keep the capital gains up to the $17 strike price, or $1.72 per share. In addition to this, you also receive 29 cents per share of income from selling the call options contract. It may not seem like much, but it has the ability to boost profits by 7.6% over the year (based on annualizing the 3 months call options contract price of 29 cents). Of course, your capital gains are also capped if share prices make a huge run beyond the $17 strike price.

 

3. Hedging Risk with Volatile Stocks

Risk goes way up when you hold shares in extremely volatile stocks. Buying call or put options for speculative trading can also be pricey since options derive much of their value from volatility. In such a case, you can buy the stock and sell call options that are “deep in the money” to protect against a significant decrease in stock price. “Deep in the money” refers to when the strike price is well below the current price. Thus, you have some protection against a downward fall, as well as a decent upside gain. Consider this example to see how it is carried out:

 

Solar stocks have high potential but a correspondingly high risk. One such stock, Energy Conversion Devices (NASDAQ: ENER), trades at $2.02 per share.

 

You acquire 100 shares at $2.02 per share.

You sell a call options contract with a $1.00 strike price for $1.27 per share and expires in 21 months.

Your effective cost basis per share is $0.75 per share.

Your maximum upside is $0.25 per share, or the difference between your net cost and the strike price.

 

How is this maximum upside calculated? Since your strike price is set at $1.00, you have essentially sold the rights on your stock above this amount. To put this another way, you will retain ownership up to $1.00, but if the price ends up above $1.00, the options will be exercised. Your potential reward is the difference between the $0.75 of net cost and the $1.00 of payment when the options are exercised at any amount above this. Thus, even if share prices fall to $1.00 (or a 50% drop from when you purchased it) and the rights are not exercised, you still made a 33% profit by turning 75 cents into one dollar. This is a great strategy when you’re invested in a stock that you believe has a high probability to suffer a significant decrease in price.

 

Final Word

 

Writing call options on stock you own is a powerful and versatile investing tool that, when properly wielded, can boost dividends, create an extra income stream, and hedge against a downside risk. However, just because a stock is optionable and you are able to write covered calls on it, doesn’t necessarily mean that you should do so. Always analyse stocks on an individual basis, and assess whether you want to trade it based on business fundamentals, risk factors, and potential reward.

 

Source: Kurtis Hemmerling

Option Trading Tips – Covered Calls

Posted on admin No Comments

Writing Covered Calls is a conservative strategy where you buy a stock that you would like to invest in and then write a call option against that stock.

 

This is a cash generating strategy that not only offers downside protection that you otherwise wouldn’t enjoy if you just bought the stock, but also gives you the ability to generate a consistent monthly income, for only minutes of your time.

 

However as with all option trading strategies, there are pitfalls that you will need to avoid if you are to be consistently profitable.

 

Here are a few tips that may help you write covered calls successfully.

 

Always check the fundamentals of the underlying stock and make sure that you would be happy to own even if options didn’t exist.

 

A great resource for viewing fundamental ‘ratings’ for stocks is at http://www.morningstar.com

 

Don’t enter a Covered Call trade just because the option premium looks attractive. Higher option premiums (10-15% or more) often mean that the stock is more volatile i.e. prone to huge price swings and therefore greater risk.

 

I personally target the larger, more liquid and stable companies with monthly call option premiums between the 3-6% range.

 

One of my personal favourites and a stock that I have had considerable success writing covered calls on over the years is Oracle (ORCL).

 

I’ve also had consistent success with Intel (INTC) and Nokia (NOK). At times the Nasdaq Tracking Unit (QQQQ) is also attractive (a 3% yield is the highest I’ve ever seen it though).

 

Don’t hold stocks at least 2 days either side of earnings announcements. Much of the time expectations of good and even great earnings are already priced into the stock and should the stock fall short of expectations or even worse disappoint, a virtual bloodbath can follow. I’ve experienced declines of 30-50% in just a few days by holding my covered call stocks over earnings announcements.

 

Don’t get me wrong, it can also be good time to be a stockholder if the earnings numbers are really great, but I’m a little more conservative and to me it’s just not worth the risk. You can always buy back in afterwards anyway!

 

Always take a look at stock charts when choosing a stock to write covered calls on. There are 3 general patterns that I look for:

 

1) A moderate uptrend.

 

2) A sideways trend.

 

However the most conservative/safe chart pattern for covered call writing (in my experience) appears after a stock has had a steep sell off and has begun to move sideways for a couple of months.

 

This is a type of ‘bottoming’ pattern where much of the downside risk has already been ‘sold’ out of the stock.

 

As covered call writers it’s always important to remember that our risk lies if the stock falls sharply, so we want to do our best to reduce the risk as best we can. This is just one way that I have found to be effective.

 

If you go to http://www.stockcharts.com and pull up the chart for the QQQQ during the early part of 2003, you’ll see this exact pattern. I successfully wrote covered calls on the QQQQ for about 4 months during this time before I allowed myself to be assigned and moved onto another opportunity.

 

There you have it. Hopefully these tips help you on your way to consistent profits and monthly cashflow writing covered calls.

 

Oh, it also goes without saying but I’ll say it anyway, “Don’t put all your eggs in one basket!”

 

For more information on how to write covered calls go to: http://www.callwriter.com

 

Happy option trading and investing!

 

Source: James Thomas

 

Covered Calls Generate More Income At Low Risk

Posted on admin No Comments

Covered calls refers to a low risk options strategy involving an investor owning call options as well as the asset underlying the options. It is probably the lowest risk options strategy that can be devised. The primary purpose is to generate income. The income is generated by selling the call option.

 

Selling call options opens up an investor to the risk of the options being exercised requiring the investor to supply the underlying shares. Under a covered call strategy, the investor already owns the underlying shares largely avoiding any negative consequences from this risk. The share ownership covers, or offsets the risk of, the call options.

 

Under the strategy the investor, by definition, holds a long position in both options and the underlying asset. If the price of the asset rises so that the owner of the options exercises the option and makes a call on the asset, the investor already owns the asset and simply transfers that ownership to the option owner. The investor receives the appreciated price for that asset. Naturally, the investor benefits to the extent that the price of the asset has appreciated.

 

The strategy is also known as a Buy Write strategy. The investor buys the underlying asset and then writes (or sells) the call options. The strategy is used when the investor has a short term neutral to negative view on the asset and for this reason hold the asset long and simultaneously holds a short call option position.

 

An example may help illustrate the strategy. An investor buys one hundred shares in AAA Company at one hundred dollars per share. The investor expects the price of these shares to remain flat or maybe even fall over the next few months.

 

Following the share purchase, our investor also sells ten thousand call options on XYZ shares at thirty cents for each option. The call options have a six dollar strike price and a two month expiry. This call option sale generates a three thousand dollar income for our investor.

 

Three outcomes are possible regarding the XYZ share price over the next two months. Firstly, it will stay constant within a band of five to six dollars. Secondly, it will decrease below five dollars. Thirdly, it will increase above six dollars.

 

In the first two scenarios, the share options expire worthless without their owner making a call on the shares. In both these cases, our investor continues to own the XYZ shares as well as generating a three thousand dollar income from the option sale.

 

In the third scenario, exercise of the call options is triggered. The investor is obligated to sell one hundred AAA shares. Total income from the share sale is ten thousand dollars. The investor also retains the one hundred option sale income.

 

In summary, covered calls offer a low risk strategy to generate additional income from share ownership. Selling (writing) call options does place a cap on the potential share price upside an investor can gain through share price appreciation. However, this is not a major consideration since the cap can be managed by the investor by choosing an option series with an appropriate strike price.

 

Source: Tim Leary

Using the Covered Call

Posted on admin No Comments

The covered call is so often the first type of strategy an option strategist tries due basically to many investors coming from a background where they have always owned stocks. The covered call is a way to derive income from the portfolio and/or lock in some profits, to a certain degree. However, before the covered call can be employed profitably many of its nuances and certain pitfalls need to be firmly understood.

 

Basically what the covered call entails is where the option strategist buys stock in increments of 100 shares and for every 100 shares sells a call option contract against it. When the option strategist actually sells the call, they are giving somebody else the right to buy the stock at a fixed price. The word covered comes from the fact the seller of the calls is not at risk if the stock climbs higher as opposed to someone who sells uncovered or naked calls and can lose an unlimited amount if the stock moves higher. With covered call writing this upside risk is eliminated because you will always be able to deliver the shares no matter how high the stock climbs.

 

However, there are indeed risks in the covered call strategy. The position only covers you if the stock climbs through the strike price you sold the call at but it does not protect you from the losses incurred from a large drop in the underlying stock price. The covered call lowers the cost basis of the stock just by the amount of premium received. Any drop below that new cost basis would show up as losses to the position. This risk factor needs to be clearly understood by anybody wanting to use the covered call strategy.

 

Covered call writer usually fall into two different camps with two distinctly different objectives. One such type is the strategist who wants to use the strategy to generate income against stock they plan to hold regardless. The other type of covered call writer employs the strategy for the sole objective of receiving high premiums. The more effective of the two covered call approaches is writing calls against stock you are willing to hold.

 

This income seeking approach allows the investor to receive a little downside hedge and then getting paid to sell the stock at a price they see favourable. Assuming it is fundamentally a superior stock and the

investor likes it then obviously they would be more apt to assume more downside risk. In essence, they would hold the stock whether options were available or not. This approach is like getting paid by the market to place a sell order limit on the stock.

 

Now the approach that just seeks out high premiums has many pitfalls and can be very dangerous. Typically traders just selecting on high premiums do not appreciate the true downside risk of the covered call strategy. Many times just selecting on high premium they do no further investigation on the quality of the issue or for that matter does not even know what they do. In addition, the issues that have these high premiums attached are often times very speculative issues prone to large price declines if things do no go exactly right.

 

It is far better and effective if the investor concentrates on the quality of the stock first before looking at premiums. If you select fundamentally superior stocks that you would want to own for at least the intermediate term then writing covered calls can be a very profitable strategy and lower your overall cost basis of the stock. However, if you are just seeking premium and ignore the inherent strength or weakness of the stock then this type of covered call writer may have to endure some market disasters with devastating drawdowns. The bottom line is if you choose to use the covered call then by all means do so effectively.

 

Happy Trading!

 

Source: Jeff Neal

What are the advantages of selling Covered Calls?

Posted on admin No Comments

As any investor would know, a call option gives the person the right but not the obligation of buying a stock at the strike price by a certain date. When the stock price goes up, so does the value of the call option. So, the investor would buy the option hoping for the underlying share price to increase. This is one of the many day trading options that investors look out for to increase the returns.

 

One strategy that is often used by investors is to write call options. When the investor hold the underlying share for the option, then it is known as a “covered call”. The buyer of the options pays the additional premium for the right to purchase the stock at the prevailing option price at a stipulated future date. So what are the benefits of selling covered call options? There are basically three main advantages for this strategy.

 

The first one concerns cash flow. Many investors buy the stock with the main objective of selling covered calls. This is an income strategy which is less risky as it is approved by many retirement funds and can provide a steady income. The second advantage is due to hedging. There are times when investors buy the stocks of blue chip as investments for the longer term. However the stock might decline over the short term so investors hedge their position with a covered call. This strategy works when there is little upside or downside potential in the short term but big returns over the longer term. Lastly, there are investors who are looking to sell the stock at a higher price than what it is trading currently. If the stock has been trading at the fair value, the investor can get a higher price if a covered option is sold.

 

Source: Kingdom Calling

Learn about Covered Calls

Posted on admin No Comments

For those with a sizable portfolio of common stock there is a low risk trade which uses covered calls. This is a trade that sells call option contracts for immediate cash income. Because you own the underlying stock there is little risk with this type of trade. A great thing about this trading strategy is that it generates instant cash income. This is credited to your account immediately. This cash income makes it a powerful and profitable trading technique that you ought to implement.

 

Investors who have a large stock portfolio are not taking full advantage of the opportunities available to them if they do not execute these trades. Anyone who has a stock portfolio ought to be doing this income generating type of stock market trading. Experts strongly encourage those with a sizable stock portfolio to discuss this with their investment counsellors. It would be a shame to lose the income that you could be earning from doing this.

 

This is a unique type of trade because it is low risk and creates immediate income. It is a trade that can be repeated on a regular basis. Thus, it is a way to constantly create a flow of income into your brokerage account. This is real money that you can spend or invest anyway you please. An investment counsellor can explain all the technical details about how it works. The accounts are simple to open and your investment counsellor can set everything up for you.

 

This is virtually an operation that can run on automatic pilot with minimal stress and concentration on daily stock prices. In fact, even if the market goes down, you are still making income. It is a unique type of trade that anyone who owns a lot of common stock ought to be using on a regular basis. With such low risk and constant inflow of cash income, it is impossible to think of a reason not to be doing this.

 

It is easy to get started with this. Simply tell a broker what you want to do. You can open an account and begin selling call option contracts right away. You will have the peace of mind of knowing that you are earning cash income with little risk of losing anything. It is almost unbelievable how well this type of trading works for building up your net worth.

 

There is no reason to take a chance with risky and complicated investment schemes. Instead, you ought to investigate this conservative way to earn cash with your stock portfolio. The main advantage of this method is that you earn income right away. This is cash that is credited to your account and that you can use anyway you want. In addition, there is little risk with this. The combination of instant cash along with low risk is a powerful combination that you will appreciate.

 

The first step you ought to take in implementing this investment technique is to talk to an experienced and trained investment adviser. They can give you the advice you need to make good decisions with your investments. They can help you avoid common mistakes that those who do not know what they are doing often make. An experienced stock broker or investment adviser can be a big help in making good financial decisions. This is why you should consult with a skilled and talent investment counsellor.

 

Covered calls are a method to utilise your stock portfolio to create a stable inflow of cash income. If you have a sizable portfolio of stock then you should starting using stock option contracts to boost your total investment results. There are investment advisers who will help you get started.

 

Source: Tim Leary

How Covered Call Strategies Can Create Cash Flow

Posted on admin No Comments

There are a number of advantages of implementing the covered call strategies to generate income. First, it is simple and quick to put this strategy into operation. The strategy is simple to track and understand, and generates unbelievable earnings. It is also a very conservative way in which people can safeguard their portfolios against market fluctuations.

 

This strategy can create a variety of likely profits for the person who already has stocks. It is not a good idea to buy stocks for the sole purpose of implementing this strategy because there are strategies available that are more helpful. On the other hand, if a person already has a portfolio, this is a good strategy to use to increase cash flow and decrease investment risks.

 

Any type of investment can be a risk for people who are not knowledgeable about stocks and options. Investing should not be scary, rather it should be respected. When an individual has a good understanding of investments, they will be able to generate a profit.

 

Investors who know their way around stocks and options, who are serious about producing wealth, apply different strategies. They will sell the options on the stocks they already own to generate additional income. This method is much like renting the stock shares like renting out property. Purchasing investment property to rent out is how some people generate earnings.

 

How this plan works is that the owner of a certain amount of stocks will sell options valued the same as the stock. A premium is received by the seller which is considered cash flow. In short, the investor agrees to sell his or her stock by an expiration date for the option, for a particular price.

 

Although this strategy still carries a potential risk if stock prices fall, it is lowered by the income received from selling the call. For that reason it is considered more of a cautious strategy than just owning stocks. However, the earnings cannot be more than the increase in capital in the stocks up to the call option strike combined with the income of the sold calls.

 

It should be noted that when anything increases more than the option strike, a buyer can exercise their option and the seller must sell the stocks at the cost of the option strike. What this means, is that any call option that increases by the date of expiration is purchased for the amount of the option not the amount of the increase in value. On the other hand, if stock prices fall the person can recoup some loss from the income of sold options.

 

The ultimate goal of investors with portfolios is to generate cash flow to eventually be self sufficient. Covered call strategies are a conservative way to generate income. When the individual who already has a stock portfolio and is experienced and well educated in stocks and options, they will be able to use this strategy to their advantage.

 

Source: Tim Leary

 

Covered Call Option

Posted on admin No Comments

When an investor uses covered call options, the investor sells a call option while owning the stock that is the underlying security of the call options. The stock that is securing the call option may be held by the broker handling the call options.

 

Using this strategy, the investor sells a call option for the same number of shares that the investor owns. A covered call is a fairly common options trading strategy.

 

The covered call option may be called an overwrite if the investor already owned the underlying stock at the time the investor sells the call options. A covered call option is sometimes referred to as a buy-write if the investor sells the call options and purchases the underlying stock at the same time.

 

By selling the call option, the investor is giving the buyer the right to purchase the stocks at the strike price of the option. The writer of a covered call trade often is expecting that the stock will not reach the strike price.

 

If the underlying stocks don’t reach the strike price, the call options the investor sold would expire worthless. The investor would then keep the option premiums as a profit. Any gain in the value of the underlying stock that is still below the strike price could also be considered part of the seller’s profit.

 

If the underlying stock reaches the strike price, the buyer has the right to exercise the option. If the buyer exercises the option, the seller must sell the stock shares to the buyer for the strike price. If the stock price increases drastically, the seller of the call has lost money that the seller could have made by selling the stock on the market.

 

The buyer of the call option makes a profit if the stock price rises above the strike price. The buyer can buy the stock at the strike price which would be less than the market price and sell the stock to get the profit from the trade.

 

The buyer’s risk is limited to the premium paid for the call option. Buying a call option is a common practice for a beginning options investor. While buying a call option has the risk of losing the option premium paid, the potential profit is theoretically unlimited if the stock rallies and makes a major upwards move.

Selling a call option is more risky than buying one because the potential loss for selling a call can be substantial if the stock rallies and the seller is forced to sell the stock at the strike price. The potential loss of a covered call option would be the difference between the strike price and the higher stock market price for the stock minus the option premiums received for the call options.

 

Source: John Mylant

Understanding Covered Calls

Posted on admin No Comments

It is easy to become a bit overwhelmed by the information and language when you first begin learning about options trading, and covered calls in particular. But covered calls are not much different than other investment strategies. The key is to find good sources of information and to learn as much as you can before investing. The covered call strategy can be a good money making source, but it is not a “get rich quick” scheme. If you are looking to become rich quickly, then you should look for some other strategy. On the other hand, if you are interested in a consistent way to earn monthly income, then covered calls are a good choice.

A few typical questions among new covered call investors:

Covered calls are what, exactly?

Also commonly called a “Buy Write” by some investors, a covered call is simply when an investor thinks that a stock has a good long term outlook but expects that the short term will stay relatively stable and trade within a few dollars of it’s current price. In this situation, the investor will then sell call options on the stock while simultaneously holding a long position on the stock. This is in the hopes of generating some income on the premium.

What is does “long” and “short” mean where stocks are concerned?

Being “long” a security (stock) means that you own it. This is the normal case. You bought it and if it goes up in value you will make money.

Being “short” means that you have sold a security (stock) that you do not own. At some point in the future you will have to buy it back to “cover” your short position.

How do I make money with covered calls?

You sell call options to buyers that allow them to purchase at a predetermined price, and they pay you a “premium” that is yours to keep whether the option is exercised or not. This guarantees you premiums regardless of the outcome, and creates income that you can count on.

How do I know when to sell these?

Generally speaking, you are trading future upside of a given stock for the right to make money short term instead. Given this, you would sell call options on stocks that you expect to remain fairly flat in the near term. If stock A is bought at $50 per share, and you expect it to stay at or near that mark for a period of time, then selling options is a good idea. This is the basic idea, although a trusted source of information can give you much deeper investment advice to narrow the choices further. Obviously you would not want to do this on a stock you expect to jump up in the near future, as you lose too much upside.

Source: Loraine Beecham