Got 100 shares of stock? Then writing covered calls may be one of the many option trading strategies that you might want to consider. Now don’t just run out to your nearest broker, there are some basic principles to adhere to.
First, make sure that the stocks you own have options or are optionable.
This may seem like a simple thing but not all equities listed on the stock market have options. There are other items that are traded like ETFs or REITs that have options but for our purposes, we are only discussing publicly traded companies.
When you purchased your shares of stock you did so with the hope that the share
price goes up, right? But what if it takes awhile for the stock to reach the target you anticipated?
You could wait and hope for your shares to rise to a profitable dollar amount or…you could sell a covered call on those 100 shares of stock that you have just sitting there and make an additional monthly premium.
Just how does it work?
Let’s say your shares of ABC company are trading at $10 each. The call options for
the upcoming month with a strike price of $12.50 are priced at $0.50 each. Since you already own 100 shares of ABC you can sell 1 contract or 100 options for $50 ($0.50 x 100 = $50).
Always remember, options are sold per contract, not per option. For every 100 shares you own you can sell 1 options contract; 1000 options = 10 contracts.
So why would you want to sell call options anyway?
After all, you bought the stock to hold on to not to sell. That’s the beauty of this options strategy; you get to keep your stock as long as the stock price is below $12.50 on options expiration. What you are in fact doing is selling a right to buy your shares of stock for $12.50 per share.
If ABC company is trading at $10 per share why in the world would someone want to
pay $12.50 for it? The answer; because they think the price will eventually be higher than the $12.50 they paid for it.
They are trying to buy it at a discount while paying a premium to you to do so. You are writing the covered call because you think the price of the stock will remain under $12.50.
The options contract is being bought because someone believes the price will go higher than $12.50.
Since most options expire every month, with some expiring every week, you can repeat this strategy over and over again, month after month. And even if you happened to get called out and have to sell your shares of ABC at $12.50 you keep the premium you received for the option contract plus the difference from $12.50 and what you originally paid for the stock.
The lower the price you initially paid, the higher the total profit.
Make sure you always pick the best stocks.
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