The Covered Call: An Income-Generating Options Strategy
by Michael C. Thomsett
The covered call provides extra income to a buy-and-hold strategy. In exchange for this income, there is a risk of lost opportunity. If the stock’s price rises well above the fixed strike price of the call, you have your 100 shares of stock called away below current market value. For some investors, this is an unacceptable risk; for others, it is gladly accepted given the potential extra returns from writing covered calls.
In this article
- A Few Options Basics
- Selling Call Options
- Examples of Covered Calls
- Evaluations and Comparisons
- Common Options Terms
- Four Outcomes
- Guidelines
Share this article
Facebook
Twitter
E-mail
SeekingAlpha
Stumbleupon
Delicious
LinkedIn
A Few Options Basics
The popularity of options trading has grown in recent years. Many investors and traders have realized that options can be used not only to speculate, but also as a means for managing a long-term stock portfolio, taking profits without needing to sell stock, and reducing the threat of losses. Among the dozens of possible strategies, covered call writing is especially popular for its potential to generate extra income for a portfolio.
Options are intangible contracts that provide rights to their owners. A call option provides the right to buy shares. (The second type of option, the put, gives you the right to sell.) The stock involved in every call trade is the underlying security. Call options have two other specifications: the expiration date (the date on which an option expires and becomes worthless) and the strike price (the price per share at which 100 shares of an option can be bought or sold when exercised). None of these terms can be changed.
A buyer, or owner, of an option has the right to exercise the contract. In the case of a call, this means that the right involves “calling away,” or purchasing, 100 shares of the stock at the strike price. For example, if you own a 70 call and the underlying stock moves to $85 per share, that call gives you the right to buy 100 shares at $70, or $15 per share below current market value.
To read more, please become an AAII Registered User or CLICK HERE.
Discussion
Using covered calls to generate monthly income from a portfolio of stocks/ETFs is a good idea in all but a strong bull market. There is a free tutorial (with examples) and a covered call screener here:
http://www.borntosell.com
posted over 2 years ago by Mike from California
I like this strategy in a stock pickers market which I believe we are in. so rather than depending upon the use of ETF to diversify my portfolio and to capture an asset allocated return for safety and marginal return I will pursue a covered call return on a limited number of well investigated "safe stocks"
posted over 2 years ago by Richard from California
I like the strategy also and try to find stocks that pay larger than average dividends because you can still collect those dividends therefore adding to your returns.
posted over 2 years ago by Kevin from Virginia
My interest is in covered calls .You cover this area extremely well. I am interested in leaps.Can you fully explain the theory governing this method . Advise .
posted about 1 year ago by Samuel from Florida
Writing the call with a buy/write strategy can reduce your initial purchase cost. You can even write an in-the-money (ITM) call if all the possible results are acceptable to you. Writing a (deeper) ITM call is also a way to get a bonus when you want to sell a stock if you are willing to accept the risk of holding on to the stock for a while.
posted about 1 year ago by Chris from Iowa
Another aspect of covered calls that can work for you is recovery by call. Say you picked a stock because you liked the hypothesis, the financials look good. It becomes a long term buy and hold for you. With that said things go badly despite proper due diligence and the stock price drops below your entry point. Maybe you bought the peak, maybe the market reverses, maybe the industry leader misses earnings and the sector takes a hit. Whatever the reason the stock price dips, maybe not enough to get stopped out but below your entry point.
As long as the stock did not get away from you completely, the recovery by call strategy is to write covered calls repeatedly, usually for low premium levels. The premium collected each time is tracked and when you have recovered the difference between the entry point and the current stock price you can change the break even point of the position giving you a different and earlier decision point for exiting the position without a loss. Certainly if you continue to hold your belief in the security one could stay in the position... but occasionally we change our minds and want to try a different different opportunity.
For all of the billiards players out there, think of it as using a little English to improve your leave.
posted 6 days ago by Marc Abear from New Hampshire
