Writing Covered Calls
WITH THE ADVENT of the options market in 1973, institutions and individuals alike were presented with new ways of investing using numerous options strategies involving both put and call options. Investors soon discovered that one of the most conservative strategies, Covered Call Writing, could be an effective tool to enhance portfolio yield and help manage risk.
MORE THAN JUST a way to hedge your stock portfolio, selling call options against existing or new stock positions generates income and reduces downside risk. When selling (writing) a call option, you are paid premium today to agree to sell your stock at a specified price (strike price) in the future (expiration date).
MONEY RECEIVED is called the option premium and is based on the price of the underlying security and the time remaining to expiration. Unless otherwise stated, one option contract represents 100 shares of the underlying security. The premiums you collect are yours to keep regardless of what happens to your stock and effectively lowers the cost basis or breakeven of your underlying stock position. In the event the stock moves lower, this reduced downside risk makes covered calls more conservative than simply buying a stock outright.
SHOULD THE STOCK remain below the strike price at expiration, the contract expires worthless. You keep the premium received and the underlying stock position. Dividends paid prior to expiration or assignments are also yours to keep. If the stock is above the strike price at expiration, your stock will be “called away” resulting in a sale at the strike price regardless of how much higher the stock may have risen.
SUCCESS IN ANY INVESTMENT STRATEGY depends on research, consistency and discipline. At Black River Wealth Management we look for companies that meet specific fundamental criteria and also have option premiums with the potential to generate consistent returns over time. The covered call is an effective tool that can add a level of discipline to your overall strategy.
TO HELP UNDERSTAND how the covered call works, let’s take a look at the various outcomes for a hypothetical investment. For simplicity, no commissions or fees are included.
YOU WOULD PAY $9,000 FOR THE STOCK and collect $1,000 in premiums for selling the call. Your out of pocket cost for the stock is now $8,000 giving you an effective cost basis of $8 for the stock.
OPTIONS GENERALLY EXPIRE on the Saturday after the 3rd Friday of the month. So for our example, by the 3rd Friday in March the stock that you purchased could have done one of three things: it could have increased in price, it could have closed unchanged, or it could have decreased in price.
IF YOUR STOCK was to close above the strike price of $10 on options expiration day, the stock will be called away, resulting in a sale at $10 per share. It’s not necessary to place the order, the assignment happens automatically for equity options contracts that are in the money by $0.01 at expiration. The stock can be called at anytime in many cases. As stated in the Options Disclosure Document, the writer of a covered call forfeits the opportunity to benefit from any increase in value of the underlying security above the strike price. The writer also continues to bear the risk of a decline in value of the underlying security.
Option trading involves substantial risk and is not suitable for all investors. We cannot and will not guarantee that you will not lose money or that you will make money from the information found on this website and / or affiliated products / services. Past results do not guarantee future results. You can lose money trading options and the loss can be substantial. Losing trades can occur, have occurred in the past, and will occur in the future. Don’t trade with money you can’t afford to lose. Only risk capital should be invested since it is possible to lose all of your principal. Your use of this website and affiliated products / services is at your own risk. Read “Characteristics and Risks of Standardized Options” aka the Options Disclosure Document (ODD) to further understand the risks of trading options.