Covered Call Options—Easy Way to Generate Extra Income for Your Portfolio
There is a myth in personal finance that states that you should not deal with options at all, because you can lose your entire investment if it doesn’t work in your favor. Similarly, when you hear the word “options,” it’s usually followed by a few words that are usually something along the lines of “too risky” or “too difficult to understand.” Contrary to this popular belief, options are not as scary as perceived, and they come with many advantages.
In essence, options were created to minimize the risk exposure, or in other words, to let one make their portfolio immune to market fluctuations, not to destroy it.
Just like any other investment, if options are not monitored and managed properly, they can leave a dent in the portfolio.
There are many strategies investors can employ in order to hedge their portfolio against the market risk. These strategies range anywhere from buying call and put options to selling both for a specific strike price; but there is an option strategy that can also earn investors an income during the period when their stock holding isn’t doing much.
The option strategy to make an income on a stock holding is called the covered call option strategy.
At the most basic level, the covered call option strategy is simply selling a right to sell your stock in the future at a certain price—selling/writing a call option. In return, you receive a fee, which the buyer pays to buy the right.
Let’s look at an example.
Suppose you bought one hundred shares of International Business Machines Corporation (NYSE/IBM) at $180.00. You believe that the stock will rise to $225.00 by the end of next year, but at the same time, you don’t expect the stock to move much until the second half of next year. You think it should just hover below the $200.00 mark.
In this case, you can go ahead and deploy the covered call strategy. You look at the option table and find out that the call options of International Business Machines (IBM), with a strike price of $200.00, sells for $5.95, expiring in July 2013.
You then sell/write a call option, to sell your IBM shares at $200.00 in July for a price of $5.95 per share right now.
As soon as you write a covered call, the purchaser of the call option pays you $5.95 per share. Therefore, you will receive an income of $595.00 right away (since each option is 100 shares). Now, in the next six to seven months, if the stock price of IBM reaches $200.00, you will have to sell your shares at $200.00, even if your target is $225.00.
The total return on your IBM shares would be $20.00 per share on the sale of the stock, and then an additional $595.00 for writing the covered call, for a grand total of $2,595.
Now, what if the stock doesn’t reach $200.00 by July? Regardless, you will still receive a fee for your covered call, and the buyer of the call option is the one who loses money.
Similarly, if the stock price goes down, the extra income generated by the covered call will help you erase some losses. To give you some perspective, the price of IBM shares can fall to $5.95 before you start to incur any losses.
This covered call strategy can be used to generate income from a stock holding and, at the same time, provide you with some loss protection. The covered call strategy is the safest option strategy an investor can use to earn a higher return on their portfolio.
With all that said, like any other investments, there are some pitfalls that investors should consider as well. Once the investor goes ahead with the covered call strategy, they will have to pay commission and other such costs. In addition, this strategy might not work for every holding in their portfolio. If the stock is fairly cheap and doesn’t actively trade, investors will have a hard time generating income from it.