Covered Calls

| December 8, 2011 | 5 Comments

Covered calls are involved in a strategy that combines a long stock position and a short call option.

The call options are sold in equal amounts against the long underlying shares.  The strike price and expiration date of the calls can be chosen based on investment objective, market view and risk appetite.

When you write a call against a long stock position it serves two purposes.  It can generate income  and it can provide some downside protection.

For example… you purchase 100 shares of Microsoft for $25 per share, and you sell one call option for $5 per contract at a strike price of $30.

Let’s look at the outcomes…

The underlying moves higher than the strike price.  In this case, your option will be assigned.  Meaning you’ll be obligated to sell your 100 shares at $30.

But remember that you collected a premium of $5 per share for selling the covered call.  So effectively, you’ve sold your stock at $35 per share.  Subtract your initial price of the stock from the premium of the strike collected to give you your profit.

What else can happen…

The underlying stock could remain stable at $25 a share.  Here, you keep the shares, and keep the premium.

So, your adjusted basis for your next covered call write is the original price paid for the stock minus the amount of money you collected ($5) for the call option.  Which is a substantial gain.

Lastly… the underlying stock can move lower than your strike price.

This moves you into protection mode.  The amount of protection is equal to you premium collected when you put on the position.  So you’ve effectively lowered your cost basis on the stock by the amount of the premium.

Overall, covered calls can be a great way to reduce your overall risk when investing in common stocks, and generate some income to boot.

This is precisely why covered call are used so extensively by both amateur and professional investors.

 

Category: Covered Call Writing, Options Trading Strategies

About the Author ()

A former banking executive, Corey Williams is the Chief Options Strategist and co-editor of our well-known daily newsletter, Options Trading Research. Corey’s extensive experience with options goes all the way back to his days in corporate finance. It was this decade in banking where Corey discovered the most important skill an options trader can have– the ability to analyze a company or sector to determine its likely future direction. And now he’s brought this background, experience and love of options to Options Trading Research, the unique daily e-letter devoted exclusively to helping individual investors profit from the very lucrative options market.

Comments (5)

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