Introduction to Covered Calls

Let’s face it. Some investment terms and strategies seem bizarre, like a “covered call.” However, this low-risk, money-making strategy can reduce volatility in your portfolio and give your retirement income a nice monthly boost.

The Basics

A stock option allows you the chance to make money no matter how the stock market is performing. You can buy or sell 100 shares of the stock upon an agreed date in the future, this date is also known as an expiration date. The two types of options are a call and a put.

A Covered Call

A covered call is a conservative strategy that offers a nice downside “cushion.” This technique only uses call options.

A call option is the right to buy a certain number of shares of a company’s stock. The shares are purchased at a specific date in the future.  The price of the shares has already been set. Therefore, no matter what the price at the future date, the predetermined price is the price that’s paid. Investors usually use the call option when they foresee an increase in the stock price.

The strategy of a covered call involves selling the call option to someone else, so you are giving the buyer the right to sell your shares of stock. You’re doing this in exchange for cash. It’s a “covered” call because you own the underlying stock.

Here’s an example of how it works: you learned that Volkswagen has become the world’s leading car maker; you decide to purchase 100 shares of Volkswagen’s stock at $42. This is the strike price. Since you like how the company is growing, and you believe that in the short run its price will only increase to $45, you decide to sell one $45 call. Remember, one call only has 100 shares that you can sell. So, you set the price at  $1.75 per share.

VLKAY trades at $42
Buy 100 VLKAY shares at $42$4,200
Sell one $45 call at $1.75$175
Trade cost$4,025


If you learn that the price only goes up to $43, that amount would be less than what you thought, so you pocket the $175 profit from selling the call. The $175 is the premium. The premium is the downside cushion.

If the stock price rises to $50, you can either buy the call back and keep it or you can sell your 100 shares at $42.  The buyer of your stock will likely decide to exercise the call option since the stock price went up. The price rose from $42 to $50. The difference is $8 per share. This means you make a profit of $800 in addition to the premium.

Sounds too good to be true, right? Well, here’s the slight catch. You give up the stock’s profit potential when you sell the call, and the capital gain could be taxed at a long-term capital gain rate.

However, the advantage of this technique is that since the underlying stock is owned, money is made when the stock rises and the premium is kept when the stock goes down. Plus, you still have all the perks of owning the stock, such as the payment of dividends.
By Brigitte Yuille

Copyrighted 2016. Content published with author's permission.

Posted in ...