Covered Calls: Generate Income from Stocks You Already Own!

Understanding Covered Calls: A Beginner's Guide

This article will explain covered calls, a strategy for generating income from stocks you already own. We'll cover the basics, potential outcomes, benefits, and risks, and even walk through a simulated trade.

What is a Covered Call?

A covered call involves selling a call option against shares you already own. This means you're creating a new contract, giving someone else the right to buy your shares at a specific price (the strike price) before a specific date (expiration date). In return for this obligation, you receive a premium, which is cash you get to keep.

How it Works: An Example

1. Buy 100 Shares: Let's say you buy 100 shares of a company at $50 per share.
2. Sell a Call Option: You then sell a call option with a strike price of $55 for a premium of $0.50 per share. This means you receive $50 (0.50 x 100) immediately.

3. Potential Outcomes: There are two possible scenarios at the option's expiration:

   • Option Expires Out-of-the-Money: If the stock price stays below $55, the option expires worthless. You keep the $50 premium and retain your 100 shares.

   • Option Expires In-the-Money: If the stock price rises above $55, the option buyer will likely exercise their right to buy your shares at $55. You sell your 100 shares at $55 each.

Outcome 1: Option Expires Out-of-the-Money

If the stock price decreases and the call option expires out of the money, you retain your shares. The premium received effectively reduces your cost basis. For example, if you bought shares at $50 ($5,000 total) and received a $50 premium, your effective cost basis is now $4,950. While you still experience losses if the stock price declines, the premium helps offset those losses.

Outcome 2: Option Expires In-the-Money

If the stock price rises above the strike price and the call expires in the money, your shares are "called away". You are obligated to sell your 100 shares at the strike price.

• You bought 100 shares at $50 ($5,000).

• You sell 100 shares at $55 ($5,500).

• You gain $500 on the shares.

• Plus, you keep the initial $50 premium.

• Total Profit: $550.

Benefits and Risks

Benefits:

• Income Generation: Earn extra income from shares you already own.

• Reduced Cost Basis: Lower the overall cost of holding your shares.

• Win-Win (If Managed Correctly): You either keep your shares and the premium or sell your shares at a profit plus the premium.

Risks:

• Missed Upside: If the stock price rises significantly above the strike price, you miss out on potential gains. Your shares will be called away at the strike price.

• Stock Price Decline: If the stock price declines, you still incur losses on your shares, although the premium partially offsets these losses.

• Having to Sell at an Unfavorable Price: This could happen if you sold the call option too close to the current stock price, or even "in the money", and then have to sell the shares for less than you bought them for.

Key Considerations

• Comfort Level: Only sell calls on stocks you're comfortable holding long-term.

• Strike Price Selection: Choose a strike price you're comfortable selling your shares at. If you really don't want to sell the shares, choose a strike price far above the current market price.

• Understand the Trade-Off: A higher strike price means a lower premium, and vice versa. Consider your priorities.

Choosing a Strike Price

The strike price you select depends on your goals:

• Keep the Shares (High Strike Price): Sell a call far out-of-the-money. You'll receive a smaller premium, but it's less likely your shares will be called away.

• Potential to Sell (Lower Strike Price): Sell a call closer to the current price or slightly in-the-money. You'll receive a larger premium but risk having your shares called away. This strategy can be used if you are ok with reducing or exiting your position if the price goes up.

Profit and Loss Diagram

The profit and loss (P&L) diagram for a covered call shows that you lose money if the stock price drops significantly. You make money as the stock price rises, but your profits are capped at the strike price. The x-axis represents the stock price, and the y-axis represents profit and loss. Once the stock price surpasses your strike price, your profits are fixed. You can buy to close your position but can get expensive, as it eats into the total profits gained.

Trading Platform Example (Thinkorswim)

The speaker uses Thinkorswim, a trading platform by TD Ameritrade, to illustrate a covered call trade. Here's a simplified overview (keep in mind specifics may vary depending on the platform and current market conditions):

1. Buy 100 Shares: Purchase 100 shares of a stock (e.g., AMD).
2. Sell a Call Option: Navigate to the options chain for the stock. Select an expiration date and a strike price. Sell one call option contract (representing 100 shares).
3. Monitor the Trade: Track the stock price and the value of the call option as expiration approaches.

In the example provided, 100 shares of AMD were purchased at $11.85. A call option was sold with a strike price of $13, generating a premium of $0.17 per share ($17 total). The trade resulted in the option expiring out-of-the-money, keeping the shares and receiving $17.50.