Covered Calls
Risk: low
Reward: low
General Description
Buying covered calls typically entails selling out-of-the-money call options on stocks that you own.
The Thinking
This strategy is employed when you are the proud owner of a stock that you do not wish to sell but would like to earn “residual” income from. You sell out-of-the-money calls, and as long as the stock doesn't rally above the strike price, you keep the premium collected when you sold the calls and you remain in possession of the stock. Then you can do it again.
Example
You have been a long time stockholder of 1000 shares of DIS and wish to hold for many more years. DIS is currently trading at 24.4, and while you are bullish, you don't think the stock will rally too much in the next few weeks. Sell (10) 27.5 calls that expire next month for $0.90 ($900).
As long as the stock closes below 27.5 on expiration day, you keep the $900 and the stock. But if the stock rallies above 27.5, the call options will be in-the-money, and you will have a decision to make. You will need to either buy the calls back and therefore make less money or possibly incur a loss, or you can simply let the stock get “called” from you.
Remember, when you buy a call, you have the right to buy the stock at a given price. But when you sell a call, you are essentially granting someone else the right to buy your stock at a given price. There is very little risk involved because if the stock drops, you keep the premium, and you were planning on keeping the stock anyway. The possible drawback is, if the stock rallies beyond the strike price, you don't get to participate in the price appreciation.
The image below summarizes the trade with a P/L Diagram. The max gain is calculated assuming you bought the stock at 24.4 and it was called from you at 27.5. You'd make 3.10 on the stock and 0.90 on the option for a total of 4 points.
The image below summarizes the trade with a P/L Diagram. |
