Writing Covered Calls for Income
A covered call is an option strategy with which you
sell a call against shares that you already own. Basically, if you had a
stock in your portfolio that you wouldn't mind selling for a certain price,
you could then “write” a call against it. For writing such a call, you would
receive the amount of an option premium from the buyer of your
options contract. Let's say that Company XYZ OCT $15 call has a premium of
$3. Say you have 100 shares of XYZ that you wouldn't mind selling at $15 per
share. If you write a call, you will then be paid $3 per share to sell the
shares in October at $15 per share. The instruction to write a covered call
is, in broker lingo, a "sell-to-open" contract, which means that
the investor is asking to sell
a contract to open a new
If you have never traded options, the first thing you
need to know is that you require approval from your broker before you can
begin to trade. Normally, your broker will start you off at the lower end of
the options-trading scale, giving you the ability to write covered calls.
When Should You Bother?
After you understand what a covered call is, you need to know when to employ
the strategy. So, what do you need to consider? Premiums! For a
covered call to be worth your time, the option premium that you receive from
the buyer must be significant enough to warrant the writing of the contract.
Here’s an example: You have 250 shares of ABC that you bought for $17, and
the ABC Jul 20 call option trades for $1. Is the covered call a good strategy
This is a trick question slightly. The first thing you should remember about
options is that one contract controls 100 shares, so writing a call for all
250 shares isn't possible. You could sell two contracts (for 200 shares),
which would give you $200, but you have to remember to account for
transaction costs as well. Typically, the minimum fees of an option trade
range anywhere from $7 to $30, depending on who your broker is. This is why
writing calls that have premiums of less than a dollar may not be worth your
while, unless you are writing several contracts at a time.
The second thing you should consider is your expectations for ABC's stock
price. If you were waiting for a spectacular buyout of your company, you
would, by writing a covered call, forgo any upside over $21 (the $20 strike
plus the $1 premium you received). If ABC is a sleeper stock and $21 seems
appealing, then by all means, sell (or “write”) the covered call.
Now for the third scenario, which is sometimes overlooked. What if ABC's
earnings are coming up and you expect unfavorable numbers? Well, with a
covered call, you've lowered your cost to $16 ($17 minus the $1 premium). The
person who bought the option from you would not exercise it if the stock
price fell below $20.
An important thing to consider before you embark on any new trade (especially
when dealing with options) is the worst-case scenario. In the case of a
covered call, there are two possible negative outcomes. Let's look again at
the ABC example. If you wrote the Jul 20 call and ABC dropped to $10, then you
would have a loss of $6 per share (because you received a $1 premium per
On the other end of the spectrum, if a large conglomerate bought ABC for $30
per share, then you would have also lost out on the trade because you
would have obtained a profit of only $4 per share ($21 minus $17) when, had
you not written the covered call, you would have had a whopping profit of $13
One last thing to remember when dealing with outcomes is
that you have the option of buying back your call on the open market. You
would make such a move if your expectation of the stock price changed since
you wrote the covered call, or if the price of the call declined enough for
you to make a profit by buying it back at a lower price.
The covered call strategy works best for the stocks for which you do not
expect a lot of upside or downside. Basically, you want your stock to stay
consistent as you collect the premiums and lower your average cost every
month. Also, always remember to account for trading costs in your
calculations and possible scenarios.
Like any strategy, covered call writing has advantages and disadvantages. If
used with the right stock, covered calls, if they work right, can be a great
way to reduce your average cost or produce added income.
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