Buying and selling shares of stock is pretty straightforward investing, but what else can you do with your stock portfolio? How about renting it out?
Covered-call investing is a lot like buying and selling stocks, but with one major difference: You are not selling your stock outright; you are selling someone the right to buy your shares at a certain price.
When you write an option to sell stock you already own, you offer it at a certain agreed-upon price. This is called the “strike price.” In a covered call, the buyer’s agreement to buy your shares of stock at that price is called an “option.”
Therein lies the secret strength of covered calls: It’s all in the options.
In covered calls, the buyer pays you — the covered call writer — a premium for the right to buy your shares of stock at the agreed-upon price. However, the buyer does not have to exercise his right to buy them.
The option buyer gets the guarantee that you will hold the stock until the option’s expiration date, which usually is the third Friday of the month, and you get a cash premium for guaranteeing that he can buy the stock at the strike price — even if its share price rises above that.
How does this help you, the covered call writer?
It works like this:
Say you have a substantial number of shares in a company that has experienced some growth but recently has slowed down. Your stocks aren’t going down, but they aren’t really raking in the dough either. Just like a real estate investor doesn’t want his income-producing properties to sit vacant, neither do you want to sit on stocks that are not generating wealth for you.
So what can you do?
You can look at the call options and consider the covered call strategy.
Let’s say that you bought into a company at $99 per share, and it has been sitting at $100 a share for several months. You decide to sell a $101 call contract for November. The key to your profits is in the premium. The option buyer pays you a premium for the right to buy your stock from you at the $101 price by that third Friday in November. The premium you get typically is greater than the difference between the current share price and the option’s strike price — how much greater depends on the stock price’s volatility and how much time remains before option expiration. Therein lies the option writer’s incentive.
Under the covered call option, you must sell the stocks at this price if the buyer exercises his right to purchase them by the expiration date; so make sure that you only offer stocks you would be willing to part with.
If your stock on that third Friday is trading at $103 a share, the buyer can purchase your shares at $101 each. (One call option contract gives the buyer the right — but not the obligation — to buy 100 shares of the underlying stock at the strike price.) If $103 is the current price, the buyer would buy — or “call” — them from you. If he chose to turn around and sell them at $103 a share, he would make $2 per share above the strike price. His actual profit will be that $2 per share minus the premium he paid you in the first place.
You, on the other hand, would have forfeited any gain in the stock’s price above the $101 strike price of your option in return for receiving that option premium. But you still profit from the $2 per share gain in the stock’s price in addition to the cash premium you received.
What if your stock stayed below $101 by the expiration date? Well, the buyer would have no incentive to want to buy your stock at the agreed-upon price, but he would have already paid you the premium for having “locked in” the right to buy it.
You still own your stock, and you make the premium when the option expires. Even on stock that isn’t moving well or has actually lost value, you have still made a profit or covered some of your loss with the premium you received.
Sounds like a great deal, right? So why isn’t everyone doing it?
Well, not all brokers allow it or recommend it. You have to find one that will — and you also have to get educated about the right kinds of stocks that need to be in your portfolio to be offered in covered call options.
A great covered call stock is one that can potentially carry a premium of 10 percent or more, but they come with volatility. There are many Internet and blog sites that can help predict what stocks are the right ones for covered calls. Get educated, and give it a try.
Tags: covered calls, options, premium, stocks, strike price