February 15, 2011
Why Sell Covered Calls
Everyone enjoys receiving dividends. Much like receiving interest, dividends are pure passive income. The best kind. You get paid no matter what you’re currently doing — reading a book, listening to the radio, on an airplane; it doesn’t matter, you still receive the dividend. There is another kind of investment that behaves the same way — covered calls.
In order to understand covered calls, we first need to understand calls. A “call option” is an investment that gives the purchaser the right to purchase stock for a known price (called the strike price) on or before a certain date (called the expiration date). In exchange for this right the buyer pays ‘premium’ (money) to the option seller. If the buyer later decides he wants to exercise the right granted to him by the option, then the seller is forced to sell the shares at the strike price (the seller also gets to keep the option premium he received at the beginning of this trade).
Imagine Tom likes ABC Corp. He wants to buy 100 shares of ABC Corp for $30 between today (March) and three months from now, but he doesn’t have enough money to buy 100 shares. So instead, Tom buys one call option on ABC Corp stock with a strike price of 30 that expires in June. Let’s imagine ABC Corp is trading for $27 today… so Tom might pay $100 (for example) for the right to buy ABC Corp at $30 between now and June. He would do this because he thinks ABC Corp will move above $30 between today and June. If ABC Corp rises to $40 then Tom can exercise his option right and force the seller of the call option to sell him 100 shares of ABC Corp at the agreed upon strike price ($30/share). Tom will have to pay $3000 for these 100 shares, but he can then sell the shares the same day for $4000, pocketing $1000 (less the $100 in premium he paid to the seller when he bought the call option in March). On the other hand, if ABC Corp finishes below $30 in March then Tom’s option expires and he loses the $100 in premium he paid.
By selling covered calls to speculators you create recurring income. But, and this important, you only want to do it with stocks you already own. Because if the options you sold are exercised, then you will already have the stock needed to deliver. That’s why they call it a ‘covered call’… your obligation is ‘covered’ by stock you already own. If it so happens that your stock is called away then you receive the strike price per share for your stock.
Many people use covered calls to create monthly income. It is a passive strategy where you collect a little option premium each month. If one of your stocks rises above the strike price then the option buyer may exercise the option and pay you for your stock. You still made money, but you may not have made as much as you could have if you hadn’t sold the option. On the other hand, the option premium that you’ve been collecting each month provides current income and some downside protection should your stock fall in value during the option’s life. Covered calls are the single most popular of all option-based strategies and are easy to learn and sell.
This article on covered call strategies is brought to you by BornToSell. If you want to know more about covered call options you are welcome to visit Born To Sell.
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