What is a covered call?
A covered call is an investment strategy in which you buy 100 shares of a stock and sell one call option on the same stock. You receive a premium from selling the call. This premium is deposited directly into your account and is yours to keep no matter what happens. For this premium payment, you commit to delivering 100 shares of this stock to the call buyer at a predetermined price (strike price). To learn more about covered calls visit this free covered call tutorial.
There are several ways to set up a covered call. (1) You might purchase both the stock and the call simultaneously in one transaction. This is called a buy/write. (2) You may already own the stock and decide you want to sell a call to give your stock limited downside insurance.
A stock owner may feel that his stock is becoming week and may decline. The market price of this stock is $2.00 per share. Selling a $10 call with a strike price of $210 and an expiration date of 30 days in the future would reduce the cost of 100 shares to $190. If the stock did drop to $1.90 share, the call would expire (worthless) and the call seller would not have lost any money. Without the covered call, he would have lost $10. A covered call can cushion a drop in the underlying stock price.
Following are examples of how this covered call might turn out. For simplicity, commissions are not included.
Stock price = $2.00
Strike price = $2.10
Call Premium = $10
|Closing Stock Price||Buyer's Gain/-Loss||Seller's Gain/-Loss|
|$2.30||$20 Gain on Stock - $10 Premium = $10 Profit||$10 Gain on Stock + $10 Premium = $20 Profit|
|$2.10||$0 Gain on Stock - $10 Premium = $10 Loss||$10 profit on stock + $10 Premium = $20 Gain|
|$1.90||$10 Premium = $10 Loss||$10 Loss on Stock + $10 Premium = $0 Gain/Loss|
|$1.80||-$10 Premium = -$10 Loss||$20 Loss on Stock + $10 Premium = $10 Loss|
Suggestions for buying covered calls
• Trade liquid stocks, meaning stocks that have a daily volume of at least 250,000 shares. The higher the volume, the easier it will be for you to buy and sell.
• Trade liquid options. There should be enough buyers and sellers to make the stock option easy to trade.
• The shorter the time period involved, the less chance you will suffer bad news and wild fluctuations of the market. However, the shorter the time period, the less profit you are likely to make on the covered call. Even though some stocks offer weekly options, 3 to 6 weeks is optimal.
• Check to see if the underlying stock has any big events coming up. Such things as an earnings report, merger, sale of additional stock by the company, FDA approval/disapproval for a new drug may have a huge effect on the price of the underlying stock.
• If the stock is highly volatile, it may be a good idea to purchase more than 100 of the underlying shares. A fast rise in the stock price could trigger an even faster rise in the call option. This might give a wonderful jump in the stock price, but turn your covered call into a loss because the option you sold would be very expensive to buy back. The extra shares would be like insurance. The ideal way for the covered call to pan out is for the stock to rise faster than the market price of the covered call, giving you a more predictable profit.
• If you are very bullish on a stock, it may be better to buy the stock only and not the covered call. If the stock rises rapidly, the covered call will limit your upside potential.
• If you think the stock is headed downward, the covered call will only provide limited protection. In this case, it would be best not to buy the covered call.
• The overall market is a big factor when buying covered calls. Since stocks are the market, when the stock market indices are rising, it is a safer time to invest in covered calls. If it is rising rapidly, you may be better off investing in stocks or buying calls. If the rise is moderate, covered calls work well.