Anemic returns are a major issue on the minds of investors attempting to generate reasonable income from their investments. The excellent news is that there is an easy-to-learn technique to garner extra monthly income from your investment portfolio.
A covered call strategy can help deliver significant profit potential, which can fuel your retirement for years to come. Breaking down the strategy into bite-sized pieces can help you understand how to implement the process more effectively.
Read on to learn what a covered call strategy is and the risk involved with executing this type of strategy.
What Is a Covered Call Strategy?
What if there was a way to improve your income significantly in your portfolio? This is where a covered call strategy can work in your favor.
A covered call strategy is when you sell a call option and own an equivalent amount of the underlying security. This means you’d be holding a long position in an asset, then write a call option on that same stock to generate an income stream.
Another investor will buy your call option at a premium. The premium is the current market price of the call option. This price is separate from the market price of the underlying stock.
Investors don’t buy or sell naked call or put options when they take on a covered call position. Naked option buying and selling is when you buy or sell an option without owning any shares of stock. The covered call strategy involves owning the underlying stock and buying or selling call options on that same stock.
An investor’s long position in the stock is the “cover” because it means the seller can deliver the shares if the call’s buyer chooses to exercise. The price at which you choose to exercise is called the strike price.
Covered calls are considered a neutral to bullish strategy, meaning the investor expects minor increases or decreases in the underlying stock price during the option’s life.
A covered call doesn’t just bring in income on the stock you own. Some investors buy stock and sell a covered call at the same time.
The simultaneous buying of stock and selling a covered call refers to a buy-write covered call. It can help lower the cost of purchasing the new stock.
Say you are interested in a company that is trading at $100 per share and decide to buy 100 shares of the underlying stock for $10,000. If you write a covered call simultaneously and earn $500 in premium income, your purchase price reduces to $9,500.
Let’s illustrate an example below to break down a covered call.
Covered Call Example
Let’s say you recently acquired 100 shares of XYZ company, purchased at $45 a share. You predict the share price will rise to $50 in the next 1-3 months.
You want to sell an XYZ call option with a strike price of $50. Your broker informs you that the option is trading at $1. Since you have 100 shares, you get $100 today (one contract equals 100 shares), and that money gets deposited into your account.
In exchange for the $100 you obtained today, you agree to sell 100 shares of XYZ stock for $50 any time before the third Friday of the month.
Below are three scenarios that can play out:
- The stock price can rise above the strike price.
- The stock price can stay below the strike price.
- The stock price can decrease.
Let’s look at how each of these three scenarios play out.
When the Stock Price Rises Above the Strike Price
If the price of the underlying stock increases above the strike price of $50, you are ITM, or in the money. Say the stock is over $50 on expiration day, then the person who bought your call option will exercise it, meaning they’ll buy your stock from you at $50 per share.
This scenario benefits you because you receive $5,000 (100 shares x $50) plus the original $100 from selling the option. You earned a total of $5,100 on this covered call.
When the Stock Price Stays Below the Strike Price
There is no terrible news in this scenario since the stock is OTM, or out of the money, due to the strike price being higher than the share price. The stock price does not rise above the strike price but will increase a small amount. The call option you sold expires worthless, so you pocket the entire $100 premium. You will see some gains on the underlying asset, which you still own. Nothing to complain about there.
When the Stock Price Goes Down
In this scenario, the stock price has dropped below $45, which was the price of the stock when you wrote the covered call. You’re out of the money since the share price is below the $50 strike price. So, the good news is that the call option expires worthless, and you get to keep the entire $100 premium plus the stock with no further obligation.
The downside is that the value of the stock is down. However, the profit from the transaction of the call option can help offset the loss on the stock.
Risks Associated With Covered Calls
Compared to other options strategies, the covered call strategy is a lower-risk strategy. However, there is still one risk you must be aware of before getting involved.
The risk of a covered call comes from holding the stock, which can drop in price. Your maximum loss occurs if the stock plummets to zero. To compute the maximum loss per share, you take the stock’s entry price minus the option premium received.
Say you buy a stock at $10 and receive a 10-cent premium on your sold call. Your maximum loss is $10 minus 10 cents, or $9.90 per share.
Opportunity cost refers to the loss of probable gain from a different alternative. The option premium comes at a cost as it limits your opportunity cost on the stock.
Volatility and Covered Calls
The higher the implied volatility, the higher the premium, which means more income generation. As a covered call investor, you do not want to trade covered calls with low implied volatility because the premium you collect is low. You also don’t want large swings in implied volatility because this means the stock can exhibit large swings in price in either direction.
Different levels of implied volatility depend on a few factors. One of them being the earnings announcement. For example, say XYZ stock has upcoming earnings in October, and the option has an expiration date in the same month. The implied volatility is going to be much higher for October options versus September options.
Using Covered Calls To Your Advantage
When it comes to easy-to-learn strategies, covered calls are a great short-term hedge opportunity on a long stock position that allows you to earn income via the premium received.
The reason why you must consider a covered call strategy is due to the low risks involved. You might miss out on some gains from the stock if it rises, but you still profit from the premium even if the stock drops.
Now that you know how to implement a covered call strategy for your portfolio, you are one step closer to constructing a portfolio that helps you generate income.
Note: This article originally appeared at Investors Alley. The author is the Investors Alley Staff.