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Writing Covered Calls for Income

 

A covered call is an option strategy with which you sell a call against shares that you already own. Basically, if you had a stock in your portfolio that you wouldn't mind selling for a certain price, you could then “write” a call against it. For writing such a call, you would receive the amount of an option premium from the buyer of your options contract. Let's say that Company XYZ OCT $15 call has a premium of $3. Say you have 100 shares of XYZ that you wouldn't mind selling at $15 per share. If you write a call, you will then be paid $3 per share to sell the shares in October at $15 per share. The instruction to write a covered call is, in broker lingo, a "sell-to-open" contract, which means that the investor is asking to sell a contract to open a new position.

If you have never traded options, the first thing you need to know is that you require approval from your broker before you can begin to trade. Normally, your broker will start you off at the lower end of the options-trading scale, giving you the ability to write covered calls.

When Should You Bother?

After you understand what a covered call is, you need to know when to employ the strategy. So, what do you need to consider? Premiums! For a covered call to be worth your time, the option premium that you receive from the buyer must be significant enough to warrant the writing of the contract.

Here’s an example: You have 250 shares of ABC that you bought for $17, and the ABC Jul 20 call option trades for $1. Is the covered call a good strategy here?

This is a trick question slightly. The first thing you should remember about options is that one contract controls 100 shares, so writing a call for all 250 shares isn't possible. You could sell two contracts (for 200 shares), which would give you $200, but you have to remember to account for transaction costs as well. Typically, the minimum fees of an option trade range anywhere from $7 to $30, depending on who your broker is. This is why writing calls that have premiums of less than a dollar may not be worth your while, unless you are writing several contracts at a time.

The second thing you should consider is your expectations for ABC's stock price. If you were waiting for a spectacular buyout of your company, you would, by writing a covered call, forgo any upside over $21 (the $20 strike plus the $1 premium you received). If ABC is a sleeper stock and $21 seems appealing, then by all means, sell (or “write”) the covered call.

Now for the third scenario, which is sometimes overlooked. What if ABC's earnings are coming up and you expect unfavorable numbers? Well, with a covered call, you've lowered your cost to $16 ($17 minus the $1 premium). The person who bought the option from you would not exercise it if the stock price fell below $20.

Possible Outcomes
An important thing to consider before you embark on any new trade (especially when dealing with options) is the worst-case scenario. In the case of a covered call, there are two possible negative outcomes. Let's look again at the ABC example. If you wrote the Jul 20 call and ABC dropped to $10, then you would have a loss of $6 per share (because you received a $1 premium per share).

On the other end of the spectrum, if a large conglomerate bought ABC for $30 per share, then you would have also lost out on the trade because you would have obtained a profit of only $4 per share ($21 minus $17) when, had you not written the covered call, you would have had a whopping profit of $13 per share.

One last thing to remember when dealing with outcomes is that you have the option of buying back your call on the open market. You would make such a move if your expectation of the stock price changed since you wrote the covered call, or if the price of the call declined enough for you to make a profit by buying it back at a lower price.

Conclusion

The covered call strategy works best for the stocks for which you do not expect a lot of upside or downside. Basically, you want your stock to stay consistent as you collect the premiums and lower your average cost every month. Also, always remember to account for trading costs in your calculations and possible scenarios.

Like any strategy, covered call writing has advantages and disadvantages. If used with the right stock, covered calls, if they work right, can be a great way to reduce your average cost or produce added income.

 

 

 

 

 

 

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