How To Use Covered Calls
When it comes to investing many people are frightened by options and think of them as being high risk, however options can help reduce your portfolios risk in some circumstances. One way to reduce the downside risk is by writing or buying covered calls. The word covered refers to the fact that you own the underlying stock as opposed to naked calls were no stock is owned. Most of the explosive risk in calls comes when using naked calls due to the leverage that is involved. A call is just the right to buy a stock at a given price for a set amount of time. Thus much of the calls value comes from time as the set time(expiration date) gets closer the price of the call option will begin to decay if the stock price remains stable.
Example of A Covered Call
You own 1000 shares of xyz company and purchased them for $25. You fear xyz could go lower short term because of some cyclical or economic factors but still like the company long term because of its dividend and growth potential, and are reluctant to sell. You determine that you would like to sell/write calls for xyz @$27 a strike price. What this means is you are giving another investor the right to buy your xyz @$27 a share for this you will be paid. In a sense you are betting another investor that xyz will not be over $27 at a certain date and $27 becomes known as your strike price. You must also decide upon how long your option will run, obviously the longer time frame you select the on your option the more that you will receive. For this example I am going to use 2 months to make it easy, but options are listed by month and always expire on the third Friday of every month.
In April you hold 1000 shares of xyz@$25
You Write 10 Calls(note 1 call=100 shares) with a strike price of $27 Expiring in June, let say the calls trade @ $1.50
You will receive $1500 for this option
Now come June expiration if xyz trades under $27 you will keep your shares and will of pocketed $1500.
Now if xyz trades at $40 come June you will only get $27 per share plus of course the $1500 your received for writing the call.
So if the stock trades below $28.50($27+$1.50 for your call) on the expiration date you are a winner and if it trades above $28.50 you are a loser.
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