Covered Calls For Dummies
Covered Call Definition
When an investor purchases shares of a stock and then sells (also referred to as writes) call options against the stock, this is called a covered call.
Why are they Called Covered Calls?
When you sell (write) an option at whatever strike price you choose, you are contractually obligated to deliver that stock to the seller at option expiration. Its covered because you already own the underlying stock. The riskiest option is called a naked call. In the above example if you sell a call at $ 45 without buying the underlying stock (many brokerages will not allow just anyone to do this) and the stock goes to $ 100, you will be required to buy it at the $ 100 and give it to the buyer. OUCH. There is unlimited risk.
The price you receive for selling the call is the option premium. This is yours to keep and is transferred to your account immediately. If the call option expires (its below the strike price that was sold), either you sell the underlying stock and keep the premium or you keep the stock and sell more options for the next month.
If the stock price runs up and is higher than the strike price of the call that was sold, the writer has two options; surrender the stock at the higher price, forgoing the gains and keeping 100% of the premium, or buy back the call at the higher price and possibly sell next months (or weeks) to offset the difference.
Also known as a buy / write, covered call writers usually sell calls when they have either a neutral or slightly bullish or bearish outlook in the near term for the stock.
Why is it Better to be an Option Seller than an Option Buyer?
First, selling (writing) covered calls produces instant cash. The Options Clearing Council (OCC) estimates that only 10% of all options contracts are exercised, leaving 90% never being exercised. Even if that math is off a little, selling options and having them expire worthless (a good thing for the seller) has an astronomically higher probability.
Who Writes Covered Calls?
Most people do not realize that options were created for insurance against stock losses and to maximize gains. So large institutional money managers, pension funds, mutual fund, hedge funds, just about any institution that holds a large amount of stock, writes covered calls to increase their returns.
In a famous Wall Street interview, a notable fund manager said he would be fired for holding naked stock. He was naked because without the selling the covered call, the only way he could make money was to have the stock go up! If you ever wondered why these funds have huge returns while everyone else hopes for 10% a year, this is one reason.
Covered Call Caveats
There are caveats to writing covered calls though. The biggest complaint for new covered call writers is that the stock suddenly blasts way past their strike price and they miss out on the big gains. This happens. One way to minimize this is to understand the personality of your stock. If the stock is in a solid uptrend and keeping above its key moving averages, then its probably not a good candidate to write unless you choose a far out of the money strike that still has decent premium.
Conversely, if the stock is trending down, a call writer can minimize the downside by selling an in-the-money call, reducing the ownership basis. For example, if Las Vegas Sands (LVS) is at $ 45.25 and the chart is trending down, you could sell a next month $ 44 call (at the time of this writing) and collect $ 3.90, making your basis $ 41.25. In this case you just bought almost 9% worth of protection, meaning the stock can fall to $ 41.35 and you would break even. If the stock stayed at $ 45.25 you would have to give up the stock for $ 44, but you still would have $ 2.65 (out of the original $ 3.90) premium in your pocket.
Like the example above to not write if the stock is trending up, if the stock is tanking, sell and get out of the way!
Many savvy investors do this every month; creating a paycheck with minimal risk that can easily be 3% to 5% of the invested funds (thats 48% a year and 60% if compounded, meaning that no funds are withdrawn. Its important to know the various call strategies when selling covered calls.
A writer needs to understand how the stock is trending, how the stocks sector is trending and what the broad market (Dow, S&P, etc) is doing.
Tim Leary is a full time trader and writes (sells) covered calls, earning 3% to 5% monthly in bull and bear markets, with limited risk. To get a 50-page http://www.mycoveredcallwriting.com/covered-call-writing.html”>covered call writing report, click here.