Covered Calls

I am learning about writing covered calls. It sounds like a good way to generate a little extra income without too much risk.

A call option (call) is a contract for a specified period of time that allows the buyer of the option the right but not the obligation to buy shares of a given stock from the seller at a given price at anytime before the contract expires. In Europe this option can only be exercised on one specific day.

For example, John owns 100 shares of the infamous XYZ Corporation frequently used in these examples. Today these shares sell for $50.00. Five years ago, John bought these shares at $30.00. Believing that the price of his shares aren’t going to do much of anything in the next six months or so, John decides he would like to juice his returns a bit by selling a covered call option on these shares.

John goes to his broker’s website and notes that a call option for a price of $55 a share that expires three months from now is priced at $0.50. This means that one option contract (always for 100 shares) will put $50 in his pocket today. He decides to execute the trade.

Judy is convinced XYZ is going up significantly in the next six months. Being a bit of a gambler, she decides to gain control of 100 shares of XYZ without plunking down the whole $5,000 today. She goes out to her broker’s website and buys a 3 month $55 a share call option.

After three months shares of XYZ sell at $52 a share. The option expires. Judy loses $50. John sells his shares for $52. His profits are $2,200 plus the $50 premium from the option.

After three months shares of XYZ sell for $60 a share. Judy executes the call option demanding her shares at a price of $55. Judy makes a profit of $500 less the $50 cost of the option. A $450 profit on a $50 investment? Not too shabby. John does OK too. He makes a $2,500 profit plus the $50 premium from the sale of the option.

In this scenario, Judy faces a maximum loss of $50. From what I can gather that is what usually happens. I have read that the majority of options are never executed. However, there is no upper limit to her profits if the price of the underlying shares skyrockets.

The only way John can lose money selling a covered call would occur if shares of XYZ really tanks. If he wanted to sell his shares at any time in the next three months, he couldn’t do it unless he went out and bought a similar call option, since Judy owns “control” of his shares. That is not too much of a risk since if the price of the underlying shares was dropping an option to buy shares at a much higher price wouldn’t be worth too much.

John can use this strategy in two different ways. In this example he is selling covered calls to generate a little income from shares that aren’t paying him a dividend. He could also write a covered call in conjunction with the purchase of additional shares of XYZ Corporation, thereby lowering the cost per share of his purchase by $0.50.

John could also sell an option without actually owning any shares. This is called a naked option. This is very dangerous since there is no upper limit to his loss, if the stock skyrockets in price. In fact, it is unlikely that John’s brokerage house would even allow this to occur. You are not automatically granted permission to buy and sell options when you open a brokerage account. If you specifically desire that ability, you must fill out an application requesting specific permission to execute different kinds of option strategies. Based on your net worth (not including your house or retirement accounts) and your experience as an investor, your brokerage house will grant you limited abilities to execute various options strategies.

Playing with options is more dangerous than buying and selling individual shares of stocks or investing in low cost index funds.

One more thing, “Let’s be careful out there!”