Ok, so you may not be a professional day trader. But you are the type of investor who prefers trading individual stocks, options, and other securities on your own. So you’re always on the lookout for different approaches to implement within your own investment strategy.
One option trading strategy that has gained momentum among DIY investors is taking a covered call position.
What are covered call options and how do they work? What are the positives and negatives? How does the strike price factor in? If covered calls are good enough for the pros, perhaps this type of trade should find a place within your overall strategy.
What is a covered call?
A call option typically represents 100-share increments and gives the buyer an opportunity to purchase the stock for an agreed-upon share price (the strike price or exercise price) on or before a specified date (the expiration). A covered call option is a financial transaction in which the owner of 100 shares of stock sells (or writes) a call option for the same stock, which is an agreement giving an option buyer the right — but not the obligation — to purchase the 100 shares of stock at the strike price of the option contract.
The covered call strategy allows the seller to generate additional income on the transaction through an option premium, which is the amount paid by the buyer to purchase the call option. The premium is determined by looking at the stock’s option chain, which we’ll dive into later.
Because the seller already owns the stock that they may be obligated to sell at the strike price of the call at a later date, the transaction is considered “covered,” hence the strategy’s name.
Here’s an example
Let’s say Mr. Investor (the covered call writer) buys 100 shares of Company X at $30 per share. Mr. I believes the stock price will rise to $50 within two years, but is also willing to sell if it hits $40 after one year.
Mr. I decides to sell a $40 12-month call option, so he nets a $5 premium per share, according to Company X’s option chain, which is a matrix of options pricing information. These numbers include the stock’s price, projected price increases, put and call options, and expected volatility.
If Company X’s stock price continues to rise to the strike price and hits $40 before the expiration (12 months), Mr. I receives $40 per share on top of the $5 premium per share from the buyer, for a total of $45 per share — $15 (or a 50 percent) profit on his initial $30 investment.
We’ll go further in depth below about the advantages and disadvantages of covered call trades but, in this case, both Mr. I and the buyer benefited from this covered call position.
Mr. I made a 50 percent profit and no longer has to worry about selling his shares at the “right time” in order to maximize his investment, and the buyer is able to purchase the stock at a price they’re comfortable with.
The upside: limited risk
Mitigating risk makes covered calls a popular selling strategy. As you can see in the previous example, writing a covered call option on a stock he already owned allowed Mr. I to make a nice profit — and additional income via the premium — by hedging his risk and limiting his liability.
As the covered call writer, Mr. I made the return he wanted without having to keep his investment and potentially worry about the stock dropping in price. And since he didn’t sell a naked (or uncovered) call, a riskier strategy where you sell call options without owning shares of the underlying stock, he isn’t exposed to a stock that’s going up and up with only the premium to offset potential losses.
Buyers of covered calls minimize their risk as well since the purchase of the stock is limited to their terms.
The downside: limited returns
The downside of limiting your risk with a covered call means you also limit your potential return.
Let’s stick with our example: What if Company X’s stock price continues to climb and reaches $60, $70, or even $90 per share? The 50 percent return earned by Mr. I selling a $40 covered call option isn’t as impressive considering he could’ve had a 300 percent return if he didn’t sell the option and held his initial investment until it reached a $90 share price.
And what if Company X’s stock drops after Mr. I’s $30 per share investment? He could buy back the covered call at a lower price, which removes his obligation to sell the initial option. And while he doesn’t necessarily suffer a loss with the option buy-back, Mr. I still owns stock that’s worth less than what he initially paid for it.
Is it right for me?
Options trading isn’t without risk, and it can be complicated, so it’s not something you’d want to jump into without learning the ropes. But options aren’t solely for professional investors, either.
If you’re looking for an investment strategy that can help mitigate risk and earn you additional profit, covered calls could be a good (ahem) option for you. It’s not the “set-it-and-forget-it” approach some investors embrace today, so do your homework on covered call strategies and the stocks you purchase. But don’t think you need to have “Certified Financial Planner” written after your name to utilize them effectively.
Ready to elevate your investment strategy?