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Covered Calls: How Do They Work?

Last time we talked about what kind of strategies we can take in a sideways market, and here’s one good option, the covered call.

WHAT IS A COVERED CALL?

One of your rights as a stock owner is the right to sell your stock at any time for the current market price. The selling of this right to someone else in exchange for cash paid today is called “covered call writing”. What this means is that you give the option buyer the right to purchase your shares prior to the expiration date of the option at a predetermined price, known as the “strike price”.

The “call option” is a contract agreement giving the buyer of that option a legal right, without obligation, to buy a set number of shares of the underlying stock at the “strike price” at any time prior to the expiration date. When the seller of the call option is the owner of the underlying shares then the option is deemed “covered” because the owner is able to deliver these shares without having to purchase them on the open market at as yet to be determined – often higher – future prices.

 

HOW TO PROFIT FROM COVERED CALLS

To secure the right to purchase shares in the future at a predetermined price, the seller is paid a “premium” to the seller of the call option. A “premium”is the fee paid in cash by the buyer on the date he purchases the option. The seller keeps this money regardless, whether the option is exercised or not.

 

WHEN TO SELL

Selling a covered call allows you to exchange some of your stock’s future upside for money in your pocket today.

To illustrate, you purchase your stock at $50 per share with the idea that it will go up to $60 within a one-year period. Plus, you’d consider selling at $55 in six months time, aware that you are sacrificing any further upside but satisfied with this profit for the short term. This is a situation where you might find it advantageous to sell a covered call on your stock position.

Upon examining the stock’s option chain, you locate a six month call option at $55 selling for $4 a share. This $55 call option could be sold against your shares, purchased at $50, which you hoped to be able to sell at $60 within 12 months. By doing this you would be obligating yourself to sell these shares within the designated six-month period if the stock reaches the $55 price. This would leave you with the $4 per share premium and the $55 per share from the sale, a total of $59 (a return of %18) for the six-month period.

Conversely, should the stock fall to $40, for example, you will have a $10 loss based on your original position. However, the $4 option premium from your sale of the call option, which you keep, offsets the total loss, making it only $6 per share instead of $10.

 

 

Scenario One

Shares go up to $60, and the option is exercised

January 1

You buy XYZ shares at $50 January1

You sell XYZ call option for $4 today
Option expires on June 30, exercisable at $55 June 30

Stock finishes at $60; option is exercised because it is above $55. You receive $55 for your shares. July 1

Total Profit: $5 (capital gain in the stock) + $4 (premium collected by you from sale of the option) = $9 per share, or 18%

 

Scenario Two

Shares drop to $40, and the option is not exercised

January 1

You buy XYZ shares at $50 January 1

You sell XYZ call option for $4 today
Option expires on June 30, exercisable at $55 June 30

Stock finishes at $40; the option is not exercised and expires, worthless, because the stock has finished below the strike price. ( Why would the option buyer still want to pay $55/share when he or she can purchase it in the market at the current price of $40?) July 1 Total Loss: -$10 + $4.00 = -$6.00, or -12%. You may sell your shares for $40 today, but you keep the $4 option premium.

ADVANTAGES OF A COVERED CALL

Selling a covered call option is a good way to offset downside risk or to increase upside return. However, it also means that you trade the cash you get from the option premium today for any upside profit beyond the $59 price per share, including the $4 premium. That is to say, if your stock finishes above $59, you end up worse than if you had merely held the stock for the six months, But if your stock ends the six month period at any point below $59, you end up ahead of where you would have been without selling the covered call.

RISKS OF A COVERED CALL

For as long as you maintain the short option position, you must hold onto the shares, or else you’ll be holding what is known as a “naked call”, which, theroetically, could have unlimited loss potential should the stock go up. Because of this, if you choose to sell your shares before the option expires, you will have to buy back the option position, costing you extra money plus some of your profit.

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