We all know that there is money to be made by writing covered calls. You can always find those who will swear that it is the best strategy that exists. And then there are others who won’t touch a covered call with a ten foot pole! As with any investment there are risks and benefits associate with trading covered calls as well.
Just because someone else has had success with a particular way of investing doesn’t mean that it is a guarantee of profits for you.On the other hand, if you come across someone who won’t even think of selling call options it’s not necessarily a sign that you should shy away from that strategy.
There are benefits and risks involved when deciding to sell covered calls. It doesn’t mean that you shouldn’t invest that way. It just means that you need to be aware of the pros and cons before you decide to sell your first options contract.
So since no one likes to hear bad news, let’s discuss the benefits to your portfolio should you decide to write calls on stocks that you own.
Writing covered calls can allow you to add an extra income every month. By selling a covered call on shares that you are just holding in your portfolio you can generate an additional revenue stream above your dividends and stock appreciation. Many people just hold a stock for the dividends, but why not make extra profits from covered call selling as well! By knowing when to sell call options (and if / when you need to buy them back) you can accelerate the rate at which your stock account grows in value.
Covered call writing allows to profit from a stock that is trending sideways. If your plan is to sell a stock once it has risen a few dollars you can sometimes be frustrated when one of your holdings just dances around the same price you originally paid for it. Covered calls can give you an extra cash flow while you are waiting for your stock to rise in price.
Selling call options gives you 12 times the earning power. A stock that has options allows the owner to repeat the covered call strategy over and over again, month after month, all year long. For those who may not want to watch their stock price fluctuations every minute of the day, using the covered call strategy frees you to only make 12 trades per year.
The premium you collect from selling the call option(s) is yours to keep no matter what. Even if you are not called out at expiration, you still hold on to the cash you received from opening the position. You also don’t have to sell the stock if it doesn’t close over the strike price you sold the options at.
An often overlooked benefit to selling a covered call is that it can actually lower the cost of buying shares of stock. If you buy stock and at the same time sell your covered call this is what’s known as a buy write. If you were to buy stock and then sell covered calls at a later point in time that would just be selling a covered call.
Let’s say that you wanted to purchase shares of stock that were currently trading at $30 per share. The $30 call option for that stock is priced at $1.00. If you were to buy the stock and simultaneously sell the call options, buying the stock would only cost you $29 per share ($30 for the stock minus the $1 you receive for selling the call option). Even it you only sell covered calls to purchase stock, it still greatly lowers your cost for each position.
Selling call options against your stock automatically caps your profit potential should your stock sharply rise in value. If you sell a covered call at the $20 strike price you miss out on any profit if the stock closes above $20 on expiration. This is potentially the biggest drawback with the covered call strategy.
Opening a covered call positing doesn’t protect you from having losses either. It does however help to protect your downside risk. Your break even point when writing a call is the amount of the call option you sold subtracted from the stock you paid for each share. In our earlier example we bought stock at $30 per share. We then sold calls that were $1.00 each. Our break even in this scenario would be $29. Should the stock close below $29 at expiration, we would suffer a loss on this position.
Should the stock drop and you want to sell your position to prevent further losses, you would have to buy your call options back before you can sell any of the shares. Buying back the call options can also cause further losses to your portfolio.
In short, covered calls can be a profitable strategy if you are aware of the risks involved. Keep in mind there is no risk free way to invest in stocks other than to never buy any. You profit from your ability to manage risk, not by avoiding it.
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