Understanding Covered Calls

Having options explained to you doesn't have to be difficult or confusing. First, some put and call option basics explained:

What is a 'Covered Call' A covered call is an options strategy whereby an investor holds a long position in an asset and writes (sells) call options on that same asset in an attempt to generate increased income from the asset. This is often employed when an investor has a short-term neutral view on the asset and for this reason hold the asset long and simultaneously have a short position via the option to generate income from the option premium.

One option contract controls 100 shares of stock. However, options are quoted on a per-share basis so when you see an option price quoted at $1.50 that means it's $150 per option contract (because each contract controls 100 shares).

If you owned 100 shares of stock, you could sell 1 call option against it and receive $150.
If you owned 500 shares of stock, you could sell 5 call options against it (not 500 call options) and receive 5 x $150, or $750.

You must own 100 shares or more to do a covered call option.

Options (calls and puts) have 3 attributes to identify them:

The underlying stock they represent
The expiration date
The strike (or exercise) price

Monthly options expire on the Saturday after the 3rd Friday of their expiration month. No reason. They just do. The last day they trade is the day before they expire (i.e. they stop trading on the 3rd Friday of the month).

Strike prices are generally available in $5 increments, or in $2.50 increments for lower priced stocks, or in $10 increments for high priced stocks. There are 390,375 call options available today with different combinations of stock, month, and strike price. A covered call is an investment strategy involving two transactions. 1. You buy stock (or use stock you already own). 2. You sell a call option against that stock. The combination of being long the stock and short a call option is called "covered call." It's called "covered" because, as the seller of the option, if the call option is exercised you already own the stock you need to fulfill your obligation to deliver the 100 shares. FUN FACT: Over 75% of all options held until expiration expire worthless. That's why you should SELL options to other people. If most of them will expire worthless, why not collect some money (or rent) for them today while they still have value?

It's what you were BORN to do!

Investing in covered calls is not a get-rich-quick strategy. It's an income-oriented approach that anyone can do, and if you like receiving dividends, you'll love receiving call premium each month. If your a real estate flipper the first thing you do is spend money. With covered calls you receive money. Real estate is a lot of hard work whereas covered calls is now work.

In order to write covered calls you will need:

A brokerage account. You can also write covered calls in most retirement (e.g. IRA) accounts. Permission to do covered call writing. Many brokerage accounts allow writing of covered calls by default. If not, your broker has a simple form you fill out in order to sell call options in your account.

Writing covered calls is a simple investment strategy you can do. It does not take much time to learn, execute, or to follow the trades. Anyone can write covered calls on stocks they own. It's also the most popular options-based trading strategy (4 out of 5 option investors write covered calls).

Let me explain to you how it's done... Before we discuss covered calls, let's review the terms "long" and "short". If you are long a security if you own the security. You bought it, you own it, and you will profit if it goes up in value. This is the normal case for most investors. You buy 100 shares of XYZ stock, and now you are long XYZ.

On the other hand, you are short a security if you have sold it without owning it. Short sellers will buy the security back at a later date. The reason you would short something (sell something you don't own) is because you expect it to fall in value. You hope to buy it back at a later date for less than you sold it for today.

It is this short option that generates the income for a covered call investor.

You want the options to expire worthless for you. In the real estate flipper world making an income stream from a property involves money, time, unsure ROI, sweat and pain, and sometimes tears. In the option world, the buyer of a call option ... not you... as a covered call investor you are a seller of call options ... has the right to buy your stock at a certain price (strike price) by a certain date (expiration date). When he decides he wants your stock at that price he will call his broker and exercise his right to force you to sell your stock to him at the strike price. Options can be exercised by the option buyer at any time on or before their expiration date. The majority of options expire without being exercised at all. Of the ones that are exercised, almost all are exercised on their expiration date. Sometimes an option is exercised before expiration, which is called early exercise. Early exercise sometimes happens if the underlying stock is about to pay a dividend.

Option exercise is common when implementing a covered call strategy and it's what you want and is no big deal; it just means you receive cash for your stock, and now you can take that cash and go buy more stock or you could feel financially secure you have a system that works and is easy to implement.

Let's say you own 100 shares of MSFT stock trading around $45. Now for the covered call you're willing to sell it if it goes up 10% (to $50) in the next 3-4 weeks. You call your broker and say "Sell the near month call option on XYZ with a strike price of 50." Your broker informs you that the call option is trading for $1 today. Since you have 100 shares, you get $100 today (ignoring commissions to keep it simple). That money is deposited into your account today. In exchange for the $100 you received today, you have agreed to sell your 100 shares of XYZ stock for $50/share any time before (and including) the 3rd Friday of the month (remember, the stock is at $45 today). If the stock is over $50 on option expiration day then the person who bought your call option will exercise it -- meaning they will buy your stock from you for $50/share. So you get $5,000 plus the original $100 from selling the option, for a total of $5,100 cash into your account. If the stock is at or below $50 on option expiration day then the call option expires worthless. This is good for you since you sold the call option to someone else. You keep the $100 premium, and you keep your stock with no further obligation. Now you can sell another call option against the same stock for the following month. This is how you "generate recurring monthly income from stocks you own." So much better than real estate flipping.

Now, $100 is not a big number but this covered call example was only 100 shares for 1 month and, more important, on a percentage basis the $100 monthly income is over 2% of the cost of the stock (which was $4,500 in this example). You can repeat this process every month. Think about it: 2% month = 24%/year with much less risk than real estate or anything else in this world.Some covered calls will pay 3%, or sometimes even more, per month and this site will help you find them. Of course, you don't want to select stocks based on the call premium alone. Company research is required, too. And if you select stocks that pay dividends (we'll help you find them) then you will get the normal dividend plus monthly call premium.

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