Selling Covered Calls

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As a general rule I think options are a terrible idea for the casual investor.  For those who are simply trying to match the markets without spending a tremendous time watching their investments, options represent a significant danger.  Even for those who have experience with options, understanding all the implications of buying or selling an option can be confusing.  Covered calls however, may have a useful place in the typical investor’s portfolio.

Option Terminology

Options are defined by several values.  For the purposes of discussing options here we will assume we’re talking about an options contract on a stock, which is not always the case.  First of all, be aware that an options contract is for 100 shares of the stock.  Thus you don’t deal in tremendously small lots when dealing with options.

Each option is either a call or a put.  A call option is an option to buy a stock at a particular price on or before a particular date.  A put option is an option to sell a stock at a particular price on or before a particular date.  In both cases the date by which the decision must be made is the expiration date and the price at which you have the option to buy or sell is called the strike price.  These options also have a price which is listed in terms of a price per share.  So for example if you see a price quoted as $0.25, that means twenty-five cents per share, or $25 for the full contract, since contracts are for 100 shares.

If all of this sounds confusing let’s look at an example:

Supposing we have a stock X which is currently trading at $35 per share and it is currently January 1st.  Now suppose I buy 10 call contracts on this stock with a strike price of $37.50 and an expiration date of February 23rd (Note that expiration dates are the third Friday of a month).  Let’s suppose I pay a price $1 per share for each of these options ($100 total for each and $1,000 total since I’m buying 10 contracts) and look at what happens depending on how stock X’s price changes in that time.

If stock X does not exceed $37.50 before February 23rd my options will expire as worthless and I will lose 100 percent of my investment, assuming I do not sell the contracts before then.  If on February 23rd the price of the stock is higher than $37.50, I will be able to buy the stock at a discount, which will hopefully exceed my $1,000 investment.  So for example if the stock is at $42.00 I will make $4.50 per share on the 100 shares per contract for 10 contracts, thus making $4,500 less my initial $1,000 investment.  This means I made $3,500 on a $1,000 investment.  As you can see, options have a high risk and high reward.

In general, people often close their position before the expiration date, which of course affects the economics as well.  If I have a call option, for example, with some time left before the expiration date and the option is already “in the money” (meaning the share price is higher than the strike price for a call), then I will probably be able to sell it at a premium to the difference in the prices, because of the potential to make more money before the expiration date.

Covered Calls

So now let’s suppose instead that I want to sell a call on stock X.  I can do this without owning one; I simply have to buy it back before the expiration date.  This is very similar to shorting a stock.  Let’s look at the economics of this.  If I sell a $37.50 call for $1 per share then I make $100 per contract.   As long as the stock doesn’t go above $37.50 before the expiration date, I will get to pocket that $100 per contract.  However if the stock goes skyrocketing I will have to pay the difference between the price and my $37.50 strike price.  As you can see, this is very risky.  However, I can make this a much safer bet if I already own the stock.

Suppose I have 1,000 shares of stock X and I do not expect the price to rise significantly.  I might go ahead and sell a call with a strike price a bit above the current price.  Thus if the stock price doesn’t move above that strike price I will pocket a little money.  If the stock price does move I will still make money because of the difference between the current price and the strike price and the premium I was paid when I sold the contract (the contract’s price).

Thus if the stock goes down, I’m better off than I would have been without the call because I get the money for selling the contract.  If the stock stays flat I’m better off for the same reason.  The only time I lose is if the price goes enough above the strike price to exceed the value I was paid for the contract.  Thus I’m limiting my downside, but I’m also limiting my upside.  If stock X doubles, I’m only going to get my strike price for it, which could be thoroughly discouraging.

Why Sell Covered Calls?

There are many reasons you might not be bullish about a stock price in the short term, but not ready to sell the stock.  Tax considerations could be one example.  Another might be that the stock pays a dividend, but you’d like to limit your exposure to the stock going down in the meantime.  In fact, combining covered calls with dividend stocks can be a good way to increase your yield and limit your risk.  You might also simply want to limit your risk when entering a position by reducing your downside and upside at the same time.

Obviously there is much more to understanding the risks and benefits of covered calls, however they represent one of the few options strategies that might make sense for a casual investor.  Be sure that you thoroughly understand them before considering them however.  The vast number of variables and outcomes can confuse even the most seasoned investor.

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