Before I begin with covered Calls let me first start by saying that the information I provided on naked Puts and the information provided here on covered Calls is very cursory; so please don’t assume what I have written is all you need to know to trade Put and Call options. The absolute gospel for trading options is “Options as a Strategic Investment” by Lawrence McMillian (ISBN-13: 9780735201972). Be forewarned though, it can be a difficult read. If, however, you want to know everything there is to know about trading options then this is the book to read.
Similar to naked Puts covered Calls are a contract between the buyer and seller. In this case the seller agrees to sell shares of a given stock he or she owns, at a set price, at some point in the future. For example: In this case you (the seller of the Call option) owns shares of, let’s say, GE which you purchased for $25.00 on September 1st of the most current year and you wish to generate some additional revenue from the shares. One option (again why they’re called options) you have is to sell a Call option, let’s say, at a strike price of $26.00 with an expiration of December (again for the most current year) for $0.50.
The Call would provide you with an additional $50.00 which you receive in the form of a premium from the buyer. The premium is yours to keep whether or not the shares are called away. The buyer of the Call has the right to purchase 100 shares of GE’s stock from you for a price of $26.00 per share, which would give you an additional $100.00 (100 x $26.00 = $2,600.00 – $2,500.00 = $100.00) for the shares if they are called away before, or by, the end of December.
The actual expiration for equity options occurs on the third Friday of the given month (in this case December) and the buyer has the right to exercise the Call anytime before that date. Generally, the shares are not called away unless the price exceeds the strike price (i.e. the $26.00) by a fairly significant amount. If the share price is less than $26.00 by the expiration date, then you keep your shares and the premium you collected when you sold the Call. There is a rule, however, known as “Automatic Exercise” which, put simply, means the shares will be automatically called away on the date of expiration if the share price is within $0.01 of the strike price, or in this case $25.99.
Either way, Call options give you an opportunity to bring in some additional revenue on the shares you own. The biggest downside of this strategy is not being able to partake in any gains if the GE shares rise significantly above the $26.00 strike price. In other words, if by the third Friday in December GE shares are selling for $80.00 per share, then you will only receive the $26.00 per share outlined in the contract between you and the Call’s buyer.
Again, please know that the information provided here is very basic and that there are alternatives to giving up the shares for $26.00 per share, but this is essentially how the covered Call strategy works and I tend to use it quite often. Also, the above information does not take into consideration broker commission and fees which can eat into your profits quite substantially. That said, I like to use this strategy with large, well-established companies that pay a decent and reliable dividend as way to generate some additional income. Generally speaking, the share prices for these stalwart companies do not tend to jump dramatically in any one direction (i.e. up or down) unless there is a major event. Thus, this strategy gives you an opportunity to earn some additional money while still collecting the dividends as long as you own the shares (i.e. as long as the shares are not called away).
Note: As with the information on naked PUTs, the above information does not take into consideration broker commissions or fees.
