Last week, I told you how most investors trade call options the wrong way.
For the most part, buying call options is an exercise in speculation based on data that shows the vast majority of calls expire worthless.But there are exceptions.Today, I’m going to share the first of those exceptions with you.Call options can be effective tools for generating both income and capital gains if used properly.As you know, when you buy a call option, you have the right, but not the obligation, to buy shares of a company’s stock at a future time, and at a pre-agreed price.But when you sell a call option on shares of stock that you own, you are agreeing to sell your shares at an agreed-upon price, at a future date—if the shares close at or above that price.This is a covered call trade. It’s a favorite of investors who are looking to generate income from stocks.It’s called a covered call because you are covering the risk by already owning the shares. By owning shares of the company, you are eliminating the risk of not being able to deliver when obliged to buy or sell stock.Here’s one strategy to use while trading covered calls (I’ll outline the other within the next couple of weeks)…
Let’s assume you own 2,000 shares of Cisco Systems Inc. (Nasdaq: CSCO). You are happy to own it at current levels of $31.50, and you’ve set a target at which you would be happy to sell your shares. Let’s say that target is $35. (It’s critical that you have set a target.)
Cisco pays a nice dividend of $1.16 per year, which is a nice benefit of holding the stock. Because you have set a target price, you can now add to that dividend by creating your own “dividend.”
You can do this by selling an option against the shares that you own.
For 2,000 shares, you can sell 20 options contracts. The Cisco $35-strike-price options that expire in January are trading for 50 cents. If you sold 20 contracts, you would take in $1,000 in cash (2,000 shares x 50 cents) that you can spend or invest in more shares.
The actual trade is done by selling to open 20 contracts of Cisco January $35 call options. By entering into this trade, you’re agreeing to sell your shares at expiration or before, as long as you receive $35 for them.
If shares close below $35, you are not obligated to sell your shares, but you can keep the money you received for selling the option.
Let’s say shares close at $34.80. The next day, your account would still show that you own the shares.
Why? Well, why would someone buy your shares for $35 if they can buy them in the market for $34.80?
The $1,000 you got for entering into the obligation is yours to keep regardless. Look at it as if it were rent that you were paid for entering into the obligation. You would also participate in the full capital gain between your basis ($31.50) and the market price at expiration.
Now, let’s assume that at expiration the shares are trading above $35, at $40 per share.
You would receive $35 for your shares because that is what you entered into a contract to receive when you accepted the $1,000. The difference between the $35 and $40 would theoretically go to the person who bought the call options that you sold.
If you’re someone who would have sour grapes if that happened, then this type of strategy is not for you. Understand that the buyer of the call has about a 25% chance (at best) of benefiting from this trade as statistics show that more than 75% of call options expire worthless.
A good way to avoid the sour grapes feeling is to be disciplined enough to sell options against only shares that you are willing to sell. Keep another position uncovered so that you can benefit from the gains if the shares rally.
If the shares tank, you have a few options. You can hold on to the shares and either…
- Sell for a loss by buying back the option that you sold and then sell the shares.
- Sell another option against your holdings to generate even more income.
A successful covered-call trader looks forward to selling call options against his or her holdings as many times as possible. Each time you take in money from selling options, you are reducing your basis in the shares. The goal is to get that basis to zero or less.
Despite the reputation of being a low-risk strategy, there are risks involved.
Next week, I’ll dive into the risks of this covered call strategy and how much capital you should devote to it.
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