With names like butterflies and condors, some options strategies may seem rather exotic—and indeed, some are for sophisticated traders only. But other strategies are fairly straightforward, and can be valuable investing tools for many average investors. One such strategy to potentially generate income on stocks you own—and don’t expect to rise in price anytime soon—is the covered call.
Considering your options
Why would you want to keep a stock you didn't believe would rise in price? There can be a variety of reasons. Perhaps you are bearish on the stock in the short term, but bullish longer term. You may be uncertain as to the timing and duration of any anticipated short term negative price move and therefore do not want to attempt to time an exit and reentry into the stock. A covered call strategy could help you generate income on the stock while you wait for it to rebound.
Other reasons to hold onto a stock that you believe could decline in value might include:
Another potential benefit is that it can provide some limited downside protection—in exchange for limiting the upside potential of the stock.
The basics about options
While there are unique characteristics and risks of options, they are essentially another way to buy and sell stocks and other securities. For instance, an investor could purchase shares of XYZ Company, or buy an option to purchase shares of XYZ Company. If you buy the shares, you then own the stock. If you buy an options contract on the shares, you have the right (but not the obligation) to buy the stock before the contract expires.1
There are only two types of options: calls and puts.
Calls: The buyer of a call has the right to buy the underlying stock at a set price until the option contract expires.
Puts: The buyer of a put has the right to sell the underlying stock at a set price until the contract expires.
When you sell a covered call (also known as writing a covered call), it means that you own shares of the underlying stock and you are selling someone a call which grants them the right, but not the obligation, to buy that stock at a set price until the option expires. If you sell the option but don’t own the stock, that position is called a naked call—which is a riskier strategy, where you can actually lose more than you invest.
How a covered call strategy works
Let's say that in February you already own 100 shares of XYZ and it is trading at $30 a share. Assume that you don't think XYZ will go up over the next several months, but you do not want to sell the stock and would like to generate some additional income on the position. This is a scenario where a covered call strategy may be appropriate.
You may decide to sell one XYZ call option, which covers 100 shares of stock. Selling one XYZ call option is the equivalent of agreeing to sell 100 shares at an agreed-upon price, known as the strike price, if the option is exercised. You would do this to earn upfront income for selling the option.
In this hypothetical example, you might sell one call option that has a strike price of $33 and expires in March. The option price or value (more commonly referred to as the premium) for this option is $1.25 per contract. If the call is sold at $1.25, the premium you receive for selling it is $125, less any commissions. This is calculated as the $1.25 premium per contract, multiplied by the 100 shares that each contract controls. An option's premium is based on several factors, including its intrinsic value, time value, and implied volatility.
Potential risks and rewards of selling options
Remember, the goal of the covered call option is to generate additional income (i.e., the proceeds of the options sale) on a stock you own. The ultimate objective is to receive the income for selling the call and not have the option be assigned. If it is assigned, the writer of the options contract has the obligation to deliver the stock. Let's take a look at several scenarios that demonstrate what could go right, or wrong, with this transaction.
The underlying stock is below the strike price on the expiration date.
If the underlying stock stays below $33 a share (the strike price) until expiration and the option expires unexercised, you keep the premium on the option ($125), less any commissions. Your break-even price is $28.75 ($30 stock purchase price - $1.25 premium).
The price of the underlying stock, XYZ, moves above the strike price before the expiration date.
If the underlying stock rises above the strike price at expiration (33 in our example), the option might be exercised and you would be obligated to deliver the stock at the strike price. In this scenario, you would still keep the premium, but you would have to deliver the stock at the strike price. You would not lose money on the call; however, you would lose any upside potential gain if the stock rose above $33. This is the primary potential disadvantage of using the covered call strategy. Of course, you would keep gains in the stock up until the strike price ($33), plus the premium. Note that after you write the option, you can close the position anytime prior to expiration by buying the option back before being notified you have been assigned.
The underlying stock remains at or near the strike price before the expiration date.
This may be considered the ideal scenario for a covered call. If the underlying stock is above your break-even price but is slightly below or at the strike price by the expiration date, you keep the premium. Additionally, your stock position is relatively unchanged. Consequently, you achieve your objective of generating additional income, with the further benefit that your existing stock position does not lose value over the time period of the covered call strategy.
It is critically important to understand all the aspects of and risks involved in trading options. Only when you fully understand how options work—and ideally after getting some experience in practice trading—should you trade options. It may be well worth the effort, though, as options can be a powerful tool to help better manage your portfolio.
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