Covered Calls

Another basic strategy is the covered call, which is a two-part strategy. First you must own 100 shares of the underlying stock. Then a call is sold and the risks of going short are covered by the shares. In the event of exercise, your 100 shares are called away at the strike. As long as the strike is picked at a level higher than your original cost for those shares, the exercise is profitable in three ways. You keep the option premium, you continue to earn dividends while you hold the shares, and you have a capital gain upon exercise of the call.

Just as time is the enemy of a buyer, it is the friend of a seller.
Declining time value means more profits for sellers, making covered calls more likely to turn out profitably than buying options.

Key Point

Time works against buyers, making long option strategies difficult to execute profitably. However, for covered call selling, the same attribute works in the seller's favor, making covered calls far more profitable in most cases.

There are two possible outcomes from the covered call:
  1. The stock rises above strike. If the stock price is higher than the strike at the point of expiration, the call will be exercised and your 100 shares of stock will be called away at the strike price. With this in mind, the strike you pick for a covered call should always be higher than the price per share you paid to buy the stock. Also remember that a short call can be exercised at any time. The most likely time is the last trading day, which is the trading day (usually Friday unless a holiday) right before the third Saturday of expiration month. Calls might also be exercised on ex-dividend date or at any other time that the call is in the money. Your overall profit consists of the call premium, dividends earned, and capital gains on the stock.You can also avoid exercise with the rolling strategy. This involves closing the short call and replacing it with another call that expires later. This produces more net income because more time equals more premium. It also delays exercise in most cases. If you can roll forward and up to a higher strike, this further reduces exercise risk, or, if the short call is exercised later, a higher capital gain is earned.
  2. The stock price falls below strike. As long as the stock price remains at or below strike of the short call, that call will not be exercised. You can wait out expiration, after which the call becomes worthless and the premium is 100 percent profit; or you can close out a call and take a short-term profit on the net difference between the original sale and the closing purchase prices. You can open and then close covered calls as often as you wish.

Covered call writing is a conservative strategy because the market risk is lower than the market risk of just owning shares. This is true because the premium you earn from selling the call discounts your net basis in the stock. As long as the strike is higher than the original price per share you paid for the stock, your profit from covered calls that are exercised has three parts: call premium, dividends, and capital gains on the stock. When a call expires or is closed at a profit, you are free to repeat the strategy as many times as you wish.

Key Point

The risks to covered call writing are fairly low when compared to simply owning shares, because the premium income discounts the stock's basis.

There are three primary risks to writing covered calls:
By Michael C. Thomsett
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2016. Content published with author's permission.

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