Investors who wish to generate additional income while waiting for long term price appreciation of a particular stock in their portfolio might want to consider selling covered calls. The covered call is a strategy in which an investor/trader writes or “sells” a call option contract while simultaneously owning an equal number of shares of the underlying stock. This strategy is designed to generate additional income and is most successful when one has a neutral to slightly bullish view on the underlying stock. First, let’s examine the basics.
A call option is a contract that gives the buyer the legal right to buy shares of the underlying stock at the strike price, before the expiration date. For this right, the buyer pays the seller a premium, which the seller collects and keeps. The buyer is never obligated to purchase the shares and can allow the option to reach the expiration date, at which point it expires and becomes worthless.
For example, if Jack purchases the 12.50 Jan 2011 call option on the underlying company Activision Blizzard, Inc. (ATVI) for $0.33, he pays $33 (0.33X100) for the right to buy 100 shares of ATVI at $12.50 until expiration of date of Jan 21st 2011 (options contracts expire the 3rd Friday of the expiration month). Jack thinks that the upcoming release of World Of Warcraft: Cataclysm will generate billions in sales and additional revenue for ATVI and send the stock rocketing upward.
If the stock doesn’t close above $12.50 on Jan 21st Jack’s call option expires worthless and he loses his $33 dollar investment. In fact, Jack would need to stock to close above $12.83, (his breakeven point 12.50 +0.33) since he had to pay for the call option. However, if Jack is correct and sales of WoW send the share price of ATVI to $20.00 his call will be “in the money” and he can exercise his right to purchase the shares for $12.50 and will have gained a substantial profit.
Selling “Covered” Calls
Jill is a long term ATVI stock holder and while she believes in the long term growth of the company, she knows the stock has been stuck in a $10 to $12 trading range for the past few years. She purchased the stock at $9.00 and still believes it has room for further appreciation, but could take years. Since the stock is trading near the top of the historical trading range and likely to head back toward $10 she sells the 12.50 Jan 2011 covered call for 0.33 and receives a $33 premium for selling the contract.
At expiration if the stock is under $12.50 she keeps the $33 premium and keeps her 100 shares of ATVI, providing her some additional income. Jill repeats this strategy every few months to keep generating income. However, if the price rises over $12.50 before the Jan expiration the option has gone “in the money” and she can be randomly exercised and forced to sell her 100 shares at $12.50, regardless of how high the price rises. Since Jill bought the stock at $9, she locks in a gain of $383 ((1250+33) - 900) but misses out on any further price appreciation because she no longer holds her 100 shares.
In conclusion, selling covered calls can be used to generate additional income for investors who already hold shares in a specific company. Not all stocks allow options trading and this example doesn’t include any fees that must be paid to the broker for buying or selling options contracts. In general, one would want to sell a covered call when they have a neutral or only slightly bullish view on a particular stock, or when a stock is stuck in a clearly defined trading range.
This article on writing covered call stock options was supplied by Enni82 from Constant Content.