What Are Options | Covered Calls |Guide To Selling Covered Calls for Additional Income
Writing Covered Calls for Additional Income
A Guide to Covered Calls
Investors that would like to generate additional income while waiting for long term price appreciation of a particular stock in their portfolio might want to consider selling covered calls. This options trading strategy is accomplished when an investor/trader sells or “writes" a call option contract while simultaneously owning an equal number of shares of the underlying stock. This options strategy is designed to generate additional income and is most successful when one has a neutral to slightly bullish view.
First, what is a call option?
A call option is a contract that gives the buyer the legal right to buy shares of the underlying stock at the strike price, before the expiration date. For this right, the buyer pays the seller a premium, which the seller collects and keeps. The buyer is never obligated to execute this right to purchase the stock and can allow the option to reach the expiration date, at which point, it expires and becomes worthless.
So, a call can be bought and sold?
Before you can sell covered calls, make sure you understand the basics of how call options work.
Buying a Call Option
For example, lets imagine Scott purchases the 12.50 Jan 2013 call option on the underlying company Activision Blizzard, Inc. (ATVI) for $1.20, he pays $120 (1.20X100) for the right to buy 100 shares of ATVI at $12.50 (strike price) until expiration of date of Jan 21st 2011 (options contracts expire the 3rd Friday of the expiration month). Scott thinks that the upcoming release of Blizzard Entertainments new MMO video game will bring millions of dollars in revenue to the company and feels the stock price will rise significanlty.
If the stock doesn’t close above $12.50 on Jan 21st Scott's call option expires worthless and he loses his $120 dollar investment. In fact, Scott would need to stock to close above $13.70, (his breakeven point 12.50 +1.20) since he had to pay for the call option. However, if Scott is correct and sales of Blizzard's new MMO send the share price of ATVI to $25.00 his call option will be “in the money” (above the strike price) and he can exercise his right to purchase the shares for $12.50, then sell them at the market price of $25/share at a hefty profit.
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Selling Covered Calls for Income
Call options can also be sold. Imagine that Monica is a long term ATVI stock holder and she believes in the long term growth of the video game industry, but she knows the stock has been stuck in a $10 to $12 trading range for a number of years. She purchased the stock at $7.50 and still believes is comfortable holding her shares for the long term, but she would like to earn some additional income while she waits for the price to gradually appreciate. Since the stock is trading near the top of the historical trading range (currently $12.00) and likely to head back toward $10 she "sells to open" the 12.50 Jan 2013 covered call for 1.20 and receives a $120 premium for selling the contract. Since one call contract grants the right to control 100 shares of the underlying security the price must be multiplied by 100. By selling this covered call Monica pockets the $120 premium regardless of outcome.
At expiration if the stock is under $12.50 she keeps the $120 premium and keeps her 100 shares of ATVI, providing her some additional income. Monica could use calls with shorter expiration dates and repeat the strategy every few months, process knowing as "rolling". However, if the price rises over $12.50 before the Jan expiration the option has gone “in the money” and she can be randomly exercised and forced to sell her 100 shares at $12.50, regardless of how high the price rises. Since Monica bought the stock at $7.50, she locks in a gain of $620 ((1250+120)-7.50) but misses out on any further price appreciation because she no longer holds her 100 shares. Although the most basic options strategy, selling a covered call is not without risk. During the months prior to expiration Monica is forced to hold 100 shares of ATVI in her trading account, if the current market price were to drop dramatically, Monica's account balance would drop as well. If this were the case and Monica determined she wanted to sell her ATVI shares before any further price depreciation she could simply "buy to close" her call option, effectively terminating her contract.
Covered Call Summary
In conclusion, selling covered calls is an options investing strategy that can be used to generate additional income for investors who already hold shares in a specific company. Not all stocks allow options trading and this example doesn’t include any fees that must be paid to the broker for buying/selling option contracts. In general, one would want to sell a covered call when they have a neutral or only slightly bullish view on a particular stock, or when a stock is stuck in a clearly defined trading range.
For a broker that allows online options trading check out E-trade or optionsXpress.
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Learn about options on the web
- Options Basics: Introduction
Investopedia has a section on options basics. It is a useful resource for those that wish to learn about options.
- The Options Industry Council
OIC is by far the best and most comprehensive online options learning tool I have found. The site includes online classes and tutorials on options basics, equity options, index options, and LEAPS. If your new to options start here!