In my previous article, Great Returns Investing little of Your Own Money, I break down the basics of an option contract for you. If you don’t recall what options are, go review the article real quick. Otherwise checkout the table below to refresh your memory on the buyers and sellers of contracts.
Two Parties Involved in Options Contract
|Pays Premium to seller. There is a debit to the account of buyer.||Receives premium from buyer. There is a credit to the account of seller.|
|Has rights to exercise (buy or sell stock)||Has obligations at exercise (must buy or sell as required by contract|
In today’s article, I’m going to be breaking down one of the most basic option strategies known as a covered call or buy write which will generate income in a stagnant or declining market!
A rough patch in a relationship
A covered call is simply an options strategy in which an investor holds a long stock position and simultaneously shorts (writes) a call against that stock to try and generate income. You can think of this strategy like hitting a rough patch in a relationship with a significant other. Long-term you know that you guys will have a great relationship and may even end up getting married and having a couple of kids together. Short-term, you have really made a mistake (you forgot your anniversary, left the toilet seat up multiple times, etc.) and you know that your relationship is not going to progress further for this temporary period of time while you work things out. The covered call works just the same except you can profit off of this expected downturn! Let’s look at an example:
- Let’s say you are invested in a stock such as Disney and you believe that it will be a great long-term investment but in the short-term you think it will have a temporary decline (recall this happens with all stocks, they just don’t go straight up!).
- You sell calls against your Disney position and automatically collect premium. (remember selling calls to open means you receive premium from the buyer!)
- If Disney declines in the short-term you keep your premium and your shares (additional income stream for you!)
Understand Selling Calls
Now before we go skipping through a field of dazes thinking of an additional income stream, look back at the chart above. SELLERS HAVE OBLIGATIONS. Never forget that. Let’s go through all the stipulations of the covered call so you have all the knowledge to execute the strategy successfully.
- 1 Contract=100 Shares
- This is very important aspect to understand. In order to perform the covered call strategy, you have to own 100 shares of the underlying stock. 1 option contract represents 100 shares of stock.
- Think about if you did not own 100 shares of the stock. Selling calls is a bearish strategy. You believe that the price of the stock will decline in the future. If you are wrong, and the stock goes above the strike price, then you have to deliver 100 shares of stock to the buyer of the call, at the stated strike price.
- For example, let’s say you sold 1 Disney Call at a strike of 35 dollars at an expiration of July/31/2017.
- You collect the premium up front from selling the call and Disney is currently trading at 33.
iii. If Disney’s share price climbs above 35 dollars before July/31 the buyer has the right to exercise the call. This means you have the OBLIGATION to sell 100 shares of Disney to the buyer at a price of 35 dollars a share.
- If you sold the call without owning the underlying stock you have to go out a purchase 100 shares of the stock at whatever it is currently trading at and sell it to the buyer at 35 a share, immediately taking a huge loss.
- For this reason, you NEED to own the 100 shares to COVER yourself in case you are wrong. (Hence why it is named the covered call)
Your maximum gain from this strategy is the premium you collect initially from selling the calls. You want the stock to stay stagnant or decline some till the expiration date so that the contract expires worthless and you keep the premium(Income).
Let’s look at an option chain on Disney for another example.
You own 100 shares of Disney, it’s currently trading at 104.60 as you can see.
You decide to sell the 110 Strike, Feb 17,2017 contract and intake the premium of $92 dollars (the bid)
If Disney does not go beyond 110 by the expiration of Feb 17, then you keep you premium J
Your loss I don’t even consider to be much of a loss at all. The main thing you have to be comfortable with when you perform a covered call is forfeiting your shares if things do not go your way. If this were to happen you still keep the premium so your only loss comes from the difference in the strike price and whatever the stock is currently trading at.
For example let’s look at the previous example except this time Disney goes beyond $110 by Feb, all the way up to $112.
Even though you keep your premium, you still have to sell your 100 shares away to the buyer at the strike of $110. Since the market is trading at $112, then you missed out on addition market gains of $2 dollars per share ($112-$110) which is $200 dollar of gains (100 sharesx$2).
Covered call writing can be a great way to generate income during a declining market or a temporary decline in a stock. Make sure you read my article on options so that you fully understand the basics before investing.
Homework: Look at some stocks in which you own over 100 shares or see if there are stocks that you could purchase 100 shares of that you think would be good, long-term investments. Next look up their option chains and find out if any calls would be worth the income knowing that your shares could potentially get called away from you. Options are more complicated than stocks so don’t feel bad if you don’t pick up everything in one read!