Tuesday, March 3, 2015

Online Options Trading - The Intricacies of a Covered Call

One of the easiest trades for a beginner options trader is the Covered Call (sometimes called a buy-write transaction). Trading a Covered Call takes the lowest level of authorization (level 1) and is easy to obtain from your brokerage house. 

What is a Covered Call?
In it simplest terms, it is where you own some stock and sell an option to someone else to buy that stock at a specified strike price to generate some income.

What is Buy-Write?
Buy-Write is another name for Covered Call. The transaction is slightly different in that you are buying the stock at the same time you are selling an option to sell the stock.
How Does it Work?
To make it easy to explain in the following let's say that you already own 1000 shares of company ABC stock and its current price is $ 25.76 per share, you have no plans to sell the stock, but I am not overly concerned if it does get sold out from under me.

You will look at the options chain for a strike price above the current stock price, usually in the next month and sell the option. 
I prefer to look at the next $ 5 increment to see if it will generate enough income somewhere in the range of .75 - 1.25. Here's a bit of caution. The closer the strike price you pick to the current stock price, the greater the chance of the stock getting sold out from under you if the stock price starts moving upward very fast. 
For arguments sake; say we found a September 30 that is paying .75 per contract. We own 1000 shares of ABC stock so we can sell up to 10 contracts against it.
How do I Make Money
If you sold 10 contracts of ABC stock for 75 cents, you would generate an income of $ 750 within the time frame of the option you sold. Usually 1-2 months. This is approximately a 3% return on investment. Ex: $ 750 / (1000 shares x $ 25.76) = .03 or 3%.
On expiration Friday, you do nothing, just let the expiration expire. This way you keep the entire $ 750 (excluding any commissions and fees).
Providing the stock price never exceeded the strike sold, or the option was not exercised, you can now repeat this same trade for the next month and so on.
What Happens If the Stock Price Rises Above the Strike Price Sold?
The option will be exercised (stock sold) at the strike price of the option sold and you will keep the amount gained from the option sale plus the difference between stock entry and exercise. Here is an example:
Bought 1000 shares of ABC for $ 21.62 ($ 21,620)
Sold 10 option contracts of Sept/$ 30 for $ 750
1000 shares of ABC exercised at $ 30.00 per share ($ 30,000)
Your gain: $ 30,000-$ 21.620 + $ 750 = $ 9,130
Remember at this point, you no longer own the stock.
What Happens If the Stock Price Starts Dropping?
You do nothing, let the option expire and keep your premium from the option sold. Now you have decision to make, do you still want to keep the stock?
Over the years I have traded covered calls many times and use this as one method to generate income. If you own stock you might as well make some money from it, particularly if you are not married to it. (Don't want to risk selling it.)
Happy trading...