Read on to get a thorough covered call explanation and review before venturing into this world. Investing needs caution and understanding before taking action. Choosing the right way to go about things can bring better monetary return than going with lesser viable ways, such as with bank account savings.
Covered calls are stable.
Covered calls are an options trading strategy that can be employed by individuals looking to generate additional income from their existing stock holdings. This approach is often favored by conservative investors who seek to enhance portfolio returns while minimizing risk as much as possible.
What Are Covered Calls?
A covered call is an options strategy where an investor who owns a particular stock sells call options on that same stock. By selling a call option, the investor grants the buyer the right, but not the obligation, to purchase the underlying stock at a predetermined price (known as the strike price) within a specified period (until the expiration date). In return for selling the call option, the investor receives a premium from the buyer.
Now, the seller will own 100 shares for each sold contract. This “covers” the sold options call, in case the shares are purchased at, for example, a lower price later on before the expiration date. If each share costs around $10, then $1,000 is the minimum investment needed to both buy the 100 shares and sell the option contract.
As an example, the contract could be sold for $50 with the expiration of one month away. So if the shares don’t sell off to the contract buyer and they are retained at the period closure, the $50 will be gained income for that one month period. This is like gaining 5% on money over that time period of just a month.
It can be clearly understood that 5% over a month is vastly preferable to sitting money in the bank for a 0.5%-2% gain over the course of one full year even, which takes more time and brings much smaller returns.
These covered calls are beneficial financial instruments!
They are to be understood appropriately before venturing into them, knowing both pros and cons of course.
Expiration Date Explained
One could easily select a week away, a month away, or even several months till contract expiration. What is available is specifically according to the stock itself and the options offered for buying and selling. This part is relative indeed, and some stocks even have a couple of months as the minimum expiration dates.
The key is to find 100 shares of stock that you are both…
1. Comfortable with owning for some time
2. Okay with the monetary return potential
If the stock price remains below the strike price until the expiration date, the options contract expires worthless, and the investor keeps the premium received as profit. However, if the stock price rises above the strike price, the investor may be obligated to sell their shares at the strike price, regardless of the current market price.
So even if the shares are sold off as an obligation, the gain comes from the price rise from the value purchased at to the upper strike price, and the secondary gain from the contract pricing. These two ways of gaining are an advantage indeed.
4 Benefits Of Covered Calls
There are some uniquely special benefits involving covered call strategies, that are well worth pointing out or reviewing here. And they work long-term to ensure that money keeps flowing in. As a beginner’s tip, it’s probably best to think of getting at least $1k before beginning (can afford 100 shares of $10 stock with this), as this would at least bring some sort of viable income, some meaningful amount back monthly of say $50 more or less.
So here are the 4 benefits…
1. Income Generation: The primary benefit of covered calls is the ability to generate additional income through the premiums received from selling call options.
2. Reduced Cost Basis: By receiving premiums from selling call options, investors can effectively reduce their cost basis in the underlying stock. Should the stock still be held after option expiration, at least the 100 shares comes at a lower price. So then, buy stock interested in holding moderate to long term.
3. Downside Protection: The premium received from selling the call option provides a cushion against potential downside risk, as it partially offsets any decline in the stock price. Do buy stock that is stable though, trying to avoid new startups since they could maybe crash and evaporate in the stock market.
4. Flexibility: Covered calls offer investors flexibility, as they can choose strike prices and expiration dates based on their risk tolerance and investment objectives. Stocks can come with weekly, monthly, even multi-month expiration dates, according to the specific company stock.
To learn more about benefits and other aspects, visit the other covered call webpage for further knowledge.
Risks Of Covered Calls
It would be remiss to mention the great motives of selling covered stock options without also mentioning the drawbacks and possible downsides. Being wary and being aware of these can go a long way to staying grounded.
1. Limited Upside Potential: When selling covered calls, investors decide their max potential gains at the strike price, alongside the premium also received. If the stock price exceeds the strike price, the investor may miss out on other further upside potential. At least with this drawback, money is not lost, just the opportunity loss.
2. Obligation to Sell: If the stock price rises above the strike price, the investor may be obligated to sell their shares at the strike price, regardless of the current market price. This could result in missed opportunities if the stock continues to appreciate. Again, at least there’s no direct monetary loss.
3. Market Risk: Covered calls do not eliminate market risk, as the value of the underlying stock can still fluctuate, potentially resulting in losses. Specifically, the stock can go southward and decrease in value. That’s why it’s best to be okay with holding it either moderate or long-term in time. If one at least likes the company, ownership may last some time. Eventually with a stable company the stock price should likely increase.
What Is A Covered Call Strategy?
A proper covered call strategy involves thought beforehand, of the end result, and of both risks and benefits. Once knowledge is locked in the mind, development of action becomes easy. Just don’t bet your whole life on this one income source, since the market could go very bearish or crash.
Having an appropriate amount of overall money set aside for this income source can become a great bonus to one’s regular income. So developing this area means having the proper perspective to not rely solely on the stock market as one’s means of existence. As an example, maybe place only 30% or even up to 70% of one’s reliance on this income source alone. The remaining percentage can come from work or some other method.
What are the tactics of a covered call strategy? To implement this, investors should follow the following steps.
1. Choose an underlying stock: Select a stock that you wouldn’t mind holding for the long-term and that has options available for trading.
2. Determine strike price and expiration date: Decide on a strike price and expiration date based on your investment goals and risk tolerance.
3. Sell call options: Sell call options against your existing stock holdings, collecting premiums from the sale.
4. Monitor the trade: Keep track of the stock price and the performance of the options contract until expiration. Adjust or close the position as needed based on market conditions. Adjusting on the market does take some experience, but not too much knowledge to know one’s way around this tactical approach. This can come in time with some minimal knowledge and experience.
Covered Call Example
Let’s take a look at this covered call example, with some in-depth details listed. This is from TD Ameritrade, a brokerage for stock and options. In fact, this platform is great for beginners in both areas so it’s recommended.
Let’s review some parts here.
1. Stock listed in upper left (AAPL or Apple). The “Underlying” shows the real time “Last” price, with the bid and ask apparent.
2. The “Option Chain” is next. The dates on the left are the actual expiration dates when contracts expire. AAPL actually performs weekly closures.
3. The “Volume” is the actual contracts traded on this specific day alone. The “Open Interest” are orders placed at bid or ask levels, individuals interested in getting the contracts themselves.
4. Once one is interested in selling an option contract (covered call contract), the “Ask” is the better level since the return would be slightly higher than the “Bid” level, but this may take some time before actual selling since buyers prefer the bid price which is lower. So try the ask, or maybe meet halfway between bid and ask, to determine the viability of the contract being sold. One tip about this is that stock with high volume, such as AAPL here with over 9 million for the day (upper right area), presents better opportunity of selling at the higher price premium (the “Ask” price).
5. This premium price decided upon (bid, ask, or agreed point) determines the premium received. This premium should grow higher until reaching the maximum profit on the expiration date. Monitoring the covered call doesn’t take long, and may even be done within a few minutes weekly, or twice weekly for example.
6. The “Strike” price is the stock value price. If AAPL is currently $187.57, selling a March 15, 2024 contract for the $190 Strike would result in $3.40 for each share at the bid price, or $340 at the expiration date. Of course AAPL is expensive, so 100 shares would cost around $18,757. In the event AAPL reaches $192 on the closure date, it could sell for $190 each ($2 in missed opportunity unfortunately). $190-$187.57=$2.43 each share, for $243 profit. Add the $340 for the premium. This results in $583 total profit and stock liquidation on expiration. This is just over 3% profit in about one month (32 days, as the bracket shows near the TD Ameritrade date of contract expiration).
7. In theory, one could have gone with the $195 strike if expecting the stock to go positive much over the next month. This would have resulted in $192-$187.57, for the total of $4.43 for each share, or $443. Add the $164 premium for the grand total of $607 which is slightly more positive. And since the stock did not reach $165 strike, it would not be sold off at contract expiration and could be kept or sold for profit anyway if expecting the value to decrease.
One important consideration that comes with experience…
In a very bullish market, the strike price may be chosen to be somewhat higher than usual, to capture more positive stock value gain and not become capped at too low of profit. In a neutral or bearish market, one could play more conservatively and have the strike price more near the actual current stock price.
Conclusion
Covered calls can be an effective strategy for conservative investors looking to generate additional income from their stock holdings. By understanding the mechanics, benefits, and risks of covered calls, investors can make informed decisions and potentially enhance their portfolio returns while managing risk. As with any investment strategy, it’s essential to conduct thorough research and consider your individual financial goals before implementing covered calls in your portfolio.
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