Writing covered calls is an investment strategy that both professional and new investors use alike. One of the rights you have as a stock owner is to sell your stock at any time so long as it is at the market price.
Writing a covered call is simply selling this right you have to another person in exchange for cash. In other words, you are giving the buyer the right to purchase your shares at a predetermined price.
The buyer will then pay you, the seller, a premium for the call option. You will be paid on the same day you sell the option, and you keep the money regardless of whether the buyer exercises the option or not.
You can also use a covered call screener to help locate specific securities that meet your trading goals and increase your chances of making a profit.
If you still aren’t completely sure about what covered calls are or how they work, here are the top three things you need to know about them:
Covered Calls Do Have Advantages
The advantage to selling a covered call is you get to generate more income without more stock market risk. The reason why there is a reduction in risk is because covered calls discounts the basis there is in stock.
Covered Calls Also Come With Risks
Potential risks with covered calls include the fact that as long as the underlying price of the stock goes below the discounted basis, then you will lose money. In addition, as long as you have a short option position, you will have to hold onto your shares, or else your loss potential is massive.
You Have To Know When To Sell
In the end, your success with covered calls will come down to if you know when to sell them. Remember, by selling a covered call, you will receive cash on the same day in exchange for the future upside of the stock.
So to put this into perspective, let’s say that you paid $10 per share of a stock, and expect it to reach $25 at the end of the year, but are also willing to sell at $20 in six months to make a profit. Yes, your sacrificing the potential upside value of the stock, but you’re also making an excellent profit.
In this same example, you may find a $20 six-month call option that sells for a $1 option premium per share. If so, this would net you a $21 return per share over the six month period, as you would be obligated to sell the shares at the $20 mark within six months. But on the flip side of things, if the stock fell in value to $5, then you would lose $4 from the original price of the share (as you would still get to keep the $1 premium).
Writing covered calls are ultimately another strategy for you to gain more money from your shares, but as with any stock trading strategy, they come with advantages and disadvantages that you need to take into consideration before proceeding.