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!