The Covered Call

Covered call writing refers to the strategy by which one sells a call option while simultaneously owning the obligated number of shares in the underlying stock.

Writing covered calls against an existing stock portfolio or in combination with a new stock purchase is one of the most conservative investment strategies available.  The traditional approach to stock ownership has always been to buy, hold and prosper.  By applying a simple strategy using options, an investor can learn to generate a monthly cash return, while still benefiting from an appreciation in share value. 

Example:

Let's imagine that you have owned xyz stock for years. After multiple stock splits, you now have 1,000 shares. Pleased with the overall growth rate, you decide to hold the stock.  Rather than just sitting back in a traditional buy and hold position, you decide to use options to generate some additional income.

 With the stock at $31 you could sell ten $35 calls for the current month at $1. When you sell the covered calls, $1,000 ($1.00/share x 1,000 shares) is immediately placed into your brokerage account.

Knowing the stock price hasn't fluctuated much; you are confident that it isn't going to move higher than $35 preceding expiration.  Upon expiration of the written option, if the stock is still below $35, you keep the $1,000 you received by selling the calls, as well as your stock. You may then sell the next months option that is at or near the money, therefore repeating the process.

Should the stock rise unexpectedly above $35, and stay above $35 on expiration, you are obligated to deliver the appropriate 1,000 shares (10 contracts x 100 shares) at the strike price of $35. At this point, however you have realized both a significant gain in the stock price as well as being able to keep the premium of the purchaser.

If the market goes against you, you have lowered your cost basis by $1.00/share, meaning that you receive 1 point of downside protection by writing the calls against your stock.

By far the most important step when selling a covered call is selecting the right underlying stock. As long as the stock price does not fall, the covered call will close at a profit. The goal of the covered call investor is to locate stocks with a neutral to mildly bullish trading pattern. While it is the price of the stock that determines if the position closes at a profit or a loss, it is the price of the covered call that determines the size of the potential profit. This factor leads many covered call writers to buy stocks that have high option premiums without regard to the stocks' underlying fundamentals. Before opening a covered call trade, investors should want to own the underlying stock. If the underlying stock is not a good investment in itself, then it is also not a good covered call

Losing trades are an aspect of the business. While the main objective is to always make a profit, the second objective is simple, minimize your losses!!! There are a few avoidable mistakes common to many covered call beginners.

Money Allocation

The easiest way to lose money is to allocate too much capital into an individual position. A profitable trade can easily recover a small loss, however a large loss can leave an investor with nothing.

Buying Back The Call When The Stock Price Goes Up 

Experienced investors know how frustrating it is to have the stock rally significantly above the strike price prior to a expiration. Most often, a greater rate of return would have been realized had a call not been sold. When a stock does rally above the strike price, the first reflex for a beginner is to buy back the covered call so they can keep the stock. This decision generally leads to a greater loss.

As the stock rallies, the price of the call will appreciate in relation to stock's movement. If the investor then buys back the covered call for more than what he sold it for, he or she will often pay the top dollar for the call just to watch the stock pull back at his or her expense. 

Failing to Exit Losing Positions 

Regardless of what option strategy you are using, it is important to cut your losses.  It is simple to close a losing covered call trade. First you buy back the call that you sold (usually cheaper if the stock price has fallen). Then, sell the underlying stock that you own. Remember keep your losses small; another opportunity is just around the corner.

Subscription As mentioned, the covered call is one of the most conservative investment strategies.  Both the United States and Canadian governments have been allowing their use in sheltered investment plans for years. Optionsource.net subscribers can participate by taking advantage of our monthly top covered call opportunities. Subscribe today to learn more. Payment is quick and secure.

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