Welcome to another segment in my series about options and how to use them properly. If you are visiting for the first time please reference the previous articles in this series:
- How To Use Bull Call Spreads
- How I Use Bear Call Spreads
- How To Use Bull Put Spreads
- How To Use Bear Put Spreads
- Buying Options Is A Fool’s Errand
- Selling Options – How To Start Your Own Casino
- How To Sell Options Successfully
Today I would like to talk about another method of selling options. This method is called covered call writing.
What Is A Covered Call?
Covered calls are considered a relatively low risk and conservative option strategy that is used to produce additional income for your portfolio.
How Does A Covered Call Work?
As I have previously pointed out before a lot of people over complicate options when they are quite simple to understand. The covered call strategy is relatively straightforward. If I own 100 shares of a stock, I can sell one call option for the underlying stock. By selling the call option I will receive a premium in exchange for the obligation to sell 100 shares of the underlying security if the stock trades above the option price.
Example Of A Covered Call Strategy
I own 100 shares of CVS and it currently trades for $51.25. I wouldn’t mind selling my shares for $52.50/share, therefore I decide to give Joe the right to purchase my shares for $52.50/share anytime between now and May 17, 2013 by selling the May $52.50 call option for $1.13. I would receive $113 upfront as a premium payment that I get to keep even if Joe doesn’t exercise his right to purchase my shares. Pretty good deal right?
If shares of CVS are trading for more than $52.50 by May 17, 2013 I have the obligation to sell my shares to Joe for $52.50 no matter what the current share price is, the stock could sky rocket to $60/share and Joe would still have the right to purchase them for $52.50. Although I missed out on the huge jump in the stock price, I profited $1.25/share in capital gains when I sold my shares for $52.50 and I also profited $1.13/share when I sold the May call option.
In the event that shares of CVS are trading for less than $52.50 by May 17, 2013 it is highly unlikely that Joe will exercise his right to purchase the shares at $52.50 as he can purchase them cheaper on his own. Therefore I get to keep my 100 shares of CVS and the $113 premium I received from selling Joe the option to purchase my shares.
Next time I will show you how I personally find trade setups to maximize my success when engaging in covered call strategies.
Here’s to our Wealth!
February 11, 2013 at 8:40 pm
Excellent series Marvin. Goes against what I wrote on Yakezie.com today, but who cares!
Sellers of options seem to consistently do better than buyer of options. Whatcha think?
Sam
February 11, 2013 at 9:21 pm
Thanks Sam! I enjoyed your article, it had a lot of great points. To be honest my wife helps me tremendously in this category. She is not as experience as I am when it comes to investing, therefore she reads my articles before I publish them and if she can’t understand them, it’s back to the drawing board for me. We have had mini fights over the way I phrase and articulate some of my articles.
I agree 100% that sellers of options outperform buyers of options on a consistent basis. Don’t quote me but I believe the last statistic I saw was that 75% of all options expire worthless.
February 11, 2013 at 10:11 pm
I like covered calls. It can be bringing nice profits. I am little bit afraid selling it against the stocks I want to hold as my core portfolio, so I like buy-write covered calls against stocks which I do not mind if they are called away.
Good job Marvin.
February 13, 2013 at 11:07 pm
Thanks Martin. I do not write covered calls on the stocks I plan on owning long term but it’s still a great strategy.
February 12, 2013 at 4:36 am
Hi Marvin
Excellent post and very clearly explained – I just might be tempted to branch out into selling options!
February 13, 2013 at 11:09 pm
Thanks David, I hope you feel more comfortable selling options.
February 12, 2013 at 7:44 am
I typically shy away from selling covered options, ESPP shares notwithstanding, because most of the positions I own I want to theoretically keep forever. However, a covered call strategy is a great way to juice up the return and works especially well in a sideways market. I imagine January was a pretty rough month for call sellers though thanks to the 5-6% move up. I will employ the buy-write though with the intention of continually selling calls if the first one expires when the opportunity presents itself.
Nice, clear explanation of the covered call.
February 13, 2013 at 11:10 pm
Completely understandable JC. I feel the same exact way, I sell covered calls on stocks I believe will go up but don’t mind waiting on. I only want to own a handful of stocks forever but unfortunately I cannot over allocate my portfolio.
February 12, 2013 at 8:41 am
Great explanation of covered call writing. This strategy proves how easy it is to make a few bucks with no more risk than you were taking before.
I think you’re right on with the 75% number, btw.
February 13, 2013 at 11:11 pm
Thanks for the confirmation!
February 12, 2013 at 11:23 am
This is a great series Marvin! Covered call writing can be a great way to bring in a little additional income to your portfolio without a lot of risk. Truth be told, I need to do more of it myself.
I think you’re right on with the 75% thought. From my experience in dealing with investors I would say it’s at least that amount.
February 13, 2013 at 11:11 pm
With 75% of options expiring worthless I don’t know anyone who would want to buy them! =)
February 12, 2013 at 8:51 pm
I have always wanted to try selling covered calls. But I’m perennially afraid that I’ll have my stock called away. Which given that I intend to hold my positions forever, that seems to go against my primary investment philosophy.
But it might not be a bad way to get out of some otherwise middling stocks that I wouldn’t mind losing.
February 13, 2013 at 11:14 pm
I would never sell calls against my Dividend Kings. Like you I want to own them for a very very long time. I will talk about how I use covered calls in my next two posts =)
February 12, 2013 at 9:59 pm
Thanks for writing this post Marvin. I’ll be honest, I’ve never really looked into the more technical side of investing. However, you’ve really explained it in an easy to follow manner. Thank you!
February 13, 2013 at 11:15 pm
Thanks for the kind words Justin. I’m glad I could help!
February 13, 2013 at 1:01 am
Great explanation on this option strategy, and easy to follow. I’ve wanted to do some covered calls too but I don’t have a lot of companies with 100 shares or more, and for the ones I do have, it’s emotionally difficult for me to give them up lol. I’m very attached to my stocks and don’t want to miss out if anyone of them breaks resistance and will probably never drop back down that low again. Maybe I’ll try it out when I have more stocks some day and don’t mind selling a portion of my holdings.
February 13, 2013 at 11:16 pm
Completely understandable. No reason to sell covered calls on your favorite stocks. I use them on what most other investors might speculate on. I’ll go into more detail in my next couple posts. Thanks for stopping by!
February 13, 2013 at 1:10 am
Marvin,
Great series! I haven’t started using options yet, but when I do, I’m going to start simple and sell puts and write covered calls. What can I say, I like income, so I want to collect the premium.
They really are low risk techniques that allow a person to profit additional “dividends” on a regular basis. Sure, you can miss out if the market has a bull run and your stock takes off. But no one goes broke making a profit…
February 13, 2013 at 11:19 pm
You hit the nail on the head! NOBODY goes broke making a profit, the biggest objection to covered calls that I hear is “Well what if it goes up and it’s called away, I would have been better off just holding the stock.” I’m a man of “what is” and not “what could be.” If there is one hard lesson I’ve learned from the stock market it’s that absolutely anything goes and the top hedge fund managers in the world have been burnt trying to predict the market. I simply take what the market gives me and keep looking for other low risk opportunities. I consider this strategy picking low hanging fruit.
February 13, 2013 at 10:36 am
Great series! I have really learned quite a bit from following your options trades and now this series!
Definitely a great strategy in a sideways market, and if you are comfortable with the thought of “capping” your gain, certainly it can lock in additional returns on your holdings!
As FI Fighter said so astutely, no one goes broke making a profit.
February 13, 2013 at 11:20 pm
Thanks for stopping by and for the kind words. I’m glad I could help. I love selling options it’s something that I’ll never stop doing. I believe you can find a strategy for selling options in almost any market. Additionally if done right you can generate consistent 15-20% returns.
February 15, 2013 at 12:36 am
I’m a big fan of selling covered calls in a variety of instances. Thanks for sharing this great post!
February 17, 2013 at 2:42 pm
My pleasure! One of the best option strategies in my book.