October 29, 2017

Understanding the Covered Call

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Making an extra premium while you wait for a stock to increase sounds like a dream come true. That's what a covered call does for you. It's not an exact science. There are no guaranteed profits. There are also no limits to your losses.

Read on to learn about covered calls and when you can use them to your advantage.

What Is a Covered Call?

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You can sell a covered call on a stock you own. What you sell is a right to the buyer to buy the stock from you. The buyer buys it at a designated price and for a certain period. In order to write a covered call, you must own at least 100 shares of the stock.

You're covered because you don't have to buy the stock if the buyer assigns the option. You own the stock. You also set the strike price and the expiration date.

It's a strategy for those who feel slightly bullish about a stock's position. You think the stock will increase, but only slightly. You don't expect to make too much on the stock. In order to increase your profits, you sell the covered call. You make the premium plus any profits you make if the call is assigned.

Why Should You Sell a Covered Call?

Why would you want to obligate yourself to sell a stock you own? It's all about the profits. It's a strategy, though. You limit your profits. It has to be a position you are okay with taking.

Looking at the basics of the covered call, you make a premium, but still own the stock. Here's an example:

You own 100 shares of ABC stock. You paid $50/share, or $5,000. You write a covered call with a strike price of $55. You receive a premium of $2.50, or $250 ($2.50 x 100 shares). The call has an expiration date of 3 months. In 3 months, the market price of ABC stock is $52. The call expires worthless. You keep the premium and your stock.

In this case, it looks pretty black and white. You own a stock that is worth more now than when you bought it. Plus, you get to keep the $250 premium. If you sold your position right now, you'd make $450 profit:

$5,200 (stock's current price) - $5,000 (price paid for stock) = $200 + $250 (call option premium) = $450

If you didn't sell the call, you would have only made $200 from the stock price increase. You also have the option to hold onto the stock. You don't have to sell it. If you feel bullish about the stock, you could keep it and hope for larger profits.

Now let's see what would happen if the stock price increased even more, though.

Let's say the stock price reached $60. The buyer would then assign the call. You would have to sell your shares at $55. You lose your stock position. But, here's what your profits would look like:

$5,500 (price made on selling the stock) - $5,000 (price paid for stock) = $500 + $250 (call option premium) = $750

If you didn't write the call and sold the stock in the open market for $60/share, you would have made:

$6,000 (price made on selling the stock) - $5,000 (price paid for stock) = $1,000

In this case, you didn't get your cake and get to eat it too. You had to give up your stock ownership. You did walk away with a premium, though.

Try to sell a covered call at a strike price that is your liquidation price. At what price would you jump on the chance to sell it in the open market? This way, if the stock is assigned, you are happy with your profits.

Another reason to sell the covered call is to earn money on a decreasing stock. Let's say, for example, the stock price dove to $48 from the $50 you paid. You want to hang onto the stock and see if it makes a comeback. In the meantime, you can sell a covered call for your desired strike price. You collect the premium upfront. If the stock never hits the strike price, you walk away with a small profit and your stock.

If the stock hits the strike price, you have to sell it. If you sold the call at your liquidation price, though, you should be okay with the trade.

Protecting Yourself with a Covered Call

There's no magic formula to help you decide the right price to sell a covered call. You know what you paid for the stock and how much return you would like to make. You set the strike price based on that amount.

You might want to focus on medium volatility stocks. This gives you a 50/50 chance at selling a call that expires worthless.

For reference:

  • High volatility stock: The stock's price can significantly change in a short period. The change can be positive or negative.
  • Low volatility stock: The stock's price will remain stagnant or change very little in the near future. Again, if it does change, it can be positive or negative.
  • Medium volatility: This is a stock somewhere in between the high and low volatility stocks. It's not expected to have any drastic movements.

Focusing on medium volatility stocks gives you a higher likelihood of the call expiring worthless. You walk away with the premium and the stock in your hand.

Other Choices When Selling a Covered Call

Selling a covered call seems very black and white. Issues still arise, though.

  • Investors don't want to sell the stock upon option assignment because the market is doing too well
  • Investors don't want to hold onto the covered call any longer

Investors who want to hold on to their stock position may have another choice. You may be able to buy the stock at the current market price. You can then use that stock to sell when the buyer assigns the call. Two things must happen first. You must talk to your broker ahead of time to make these arrangements. In other words, you'll need funds in your brokerage account to buy the stock and sell it right away.

You'll also need to see if it makes sense to do so. You'll want to make more on the original stock purchase than the loss you take on the covered call. Buying the shares in the open market and selling at the strike price will likely result in a loss.

Here's an example:

You originally bought XYZ stock at $50/share. You wrote a covered call with a strike price of $55 and 3-month expiration. You made a premium of $3, or $300.

At the 3-month mark, the stock rose to $60 per share. That's much higher than you predicted. You see an instant $1,000 gain on your stock position. Plus, you think the stock may go higher. Rather than selling those shares, you buy stock on the current market. Here's how it looks:

$6,000 (price the new shares cost you) - $5,500 (price you sold them for) = $500 + $300 (premium received) = $800 profit

Now you still own the shares you purchased for $5,000. If the price continues to go up to $65 (at which point you sell), it would look like:

$6,500 (profit made on sold shares) - $5,000 (price you originally paid) = $1,500 + $800 (profit on covered call) = $2,300 profit

This situation would only happen to investors who actively watch the market and know when to move, though.

You may also decide you don't want the call option any longer. In this case, you may buy the call back. Of course, you'll have to see if it makes sense to do so. You'll want a premium that is lower than what the buyer paid you. If you wait until close to the expiration date, you'll likely nab it for a much lower premium. This way, you still make a small premium, but keep your stock.

Bottom Line

In a perfect world, the stock would hit your exact strike price and not a penny more at expiration. The call expires worthless. You keep the premium and also realize the stock gains.

Of course, we don't live in a perfect world. We live in a world where stocks are unpredictable. Selling a covered call requires research, time, and patience. It also requires catlike reflexes when things don't go the way you thought.

Utilizing the services of a great broker can help. Your broker can advise you when it's right to sell a covered call on a stock you own. It has the potential to make you a little extra money. It also has the potential to limit your profits more than you'd prefer.

Do your research and carefully evaluate your position before deciding if this option is right for you.

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