Covered Call Option Strategy

How and why to use the Covered call strategy option to earn extra income

Many investors (new and old) use the Covered call option. It is a risk “management” strategy; in this options strategy, the trader buys/owns an underlying stock and sells call options for a premium on a share-for-share basis.   The premium from selling the calls can add some nice income to your portfolio.  The Covered call strategy is the main income producing strategy I use in my portfolio to earn extra income.  I also use the Cash Secured put strategy to generate income.  My hope is that between these two strategies I can earn a nice income in my portfolio.  Below I discuss the finer details on how the strategy works.

What is a call option?

A call option is a contract that gives a buyer the legal right (however not the obligation) to buy 100 shares of the underlying investment at a specific price anytime on or before expiration.

Premium

Each of the options contracts you buy is for 100 shares. (1 call = 100 shares, 2 calls = 200 shares, 4 calls = 400 shares, and so on.)  The amount a trader pays to obtain an option is known as the premium.  The premium is calculated by multiplying the premium amount by the 100 shares.  So, a .40 premium for an option is really $40.

Out of the Money

In a covered call, most traders usually trade their stock options as Out of the Money. It occurs when an option’s strike price is lower than the market price of the underlying asset.

This way, the trader makes a profit on both the option contract sale and the sale of the stock if the price of the stock goes above the strike price.

In the Money

In a covered call, an In the Money option is where the stock price is equal to or below the strike price.

Traders sell an In the Money call option when they believe the stock price will drop and want to sell their stock and at the same time earn a premium.

Strike Price

This is a set price in the market at which you exercise the put or call options. It is normally set by the current market valuation of that underlying commodity.

Expiration

The date of expiration on a contract is the last day on which the holder of an option may exercise the rights to purchase the underlying stock.  Options typically expire on the third Friday of each month at 4pm.

Assignment

This is when the buyer of an option exercises his right to the call option. And the seller must transfer ownership of the underlying assets at the strike price (agreed price on the contract).

Income

It refers to the amount of revenue you generate by selling a Covered call option. The amount is called premiums. Also, many times, other expenses like commissions and fees. might affect your premiums significantly.  Recently, most brokers have lowered their commissions to be non-existent or nominal.

Most times, traders want to keep hold of their stock for the long term. However, these stocks might not appreciate or may even drop in value, and a trader might decide to write covered calls against the stock to cater for such changes.

The biggest advantage to selling covered call options include.

• You make income on your stock, especially in neutral to bullish markets.
• Where the stock price is rising, it allows you to higher the selling price.
• On marginal falling stocks, it offers you protection and reduces your losses.

How does selling a Covered Call option work?

Let us assume that Sam buys the original stock with 300 shares at $60 per share. And sells 3 call options

If Sam sells a 30-day August 70 XYZ call, at $2 per contract to John.

• John has the rights (but is not obligated) to purchase 300 shares of XYZ at $70 per share before/at the August expiration.
• For the call option/contract/right, John will pay an immediate sum of $2 per contract for a total of $6 to Sam. ($2 premium * 3 contracts = $6) This is the premium on the call option.

With our stock example of XYZ, imagine within the 30-day trade period, the stock increases to $68 per share and the contract expires.  Sam would have earned $600 in premium.  (Premium of $6 * 100).  This is also true if the stock decreases in value.  However, if the stock increases to $75 per share then Sam only gets the premium and $70 per share.  Meaning he has lost some of the upside of the stock.  The goal of most Covered Call writers is to have the option expire or be closed with a positive premium.

Now for every covered call option trade, there are generally three choices the trader can make.

1. Allow the contract to expire

Most times, the stock price might not move up to the strike price of the call option. Therefore, the seller (Sam) will run down the contract (since the buyer might be unwilling to buy the underlying commodity). And keep the premium

2. Assignment of the Stock

In this case, the buyer of the call options might consider the stock profitable and exercise his option to buy. The seller has no choice but to assign the underlying shares to the buyer. However, the seller keeps the premium and the amount from the sale plus profits ($70 per share with a $10 profit)

3. Buying back the call option/closing early

The Seller might want to take profits in the option before the expiration.  This is to limit the assignment risk and to clear the trade so that the trader can issue another option.  For instance, if you earn $200 in premium and the value of the contract has decreased to $15 then you can buy the option back and earn a profit of $185.  At this time, you can sell another Covered Call option.

Wrapping up

The covered call option is a good income making option and risk-limiting strategy for your portfolio. The strategy allows you to earn premiums on your investments and since you own the security this strategy is considered the safest option strategy.  Combined with Cash Secured Puts (Discussed here) you can earn a nice income from the investments in your portfolio.