So you’ve been thinking about writing covered calls to add a bit of diversity to your stock portfolio. The thing is, you’re not too certain how it works… or even what an option is, to begin with!
Not to worry, options seem to be a tricky subject for some but are really not that complicated once you get the hang of it.
What exactly is an option?
In its simplest form, an option grants an individual the right to buy a stock for a specified price. A key point to remember is that it gives one the right to buy not an obligation to buy. On the other hand, the owner of the stock must sell their shares should the option holder choose to exercise the shares.
There are two types of options; calls and puts. Call options increase in value as the underlying stock it’s tied to rises in price. Put options, however, rise in value as the stock price goes down. Since we are putting our focus on writing or selling covered calls, we will ignore puts at the moment.
Just remember: call up, put down.
Now that you understand what an option is, you can begin the search for what calls you actually want to write. Options are available on a monthly basis where they expire the third Friday of every month.
For example; a July option would expire at the close of trading the third Friday in July.
There are also options that are available on a weekly basis known as ‘weeklys’. These options are can be bought and sold beginning Thursday of every week except the week of expiration of the monthly options. Weekly options expire on Friday of the following week they are issued.
In addition to considering which month or week you would like to write your covered calls, you must also consider which price, also known as the ‘strike price’. The strike price is the price the stock will be sold at if that particular option is exercised.
Let’s look at an example.
The stock of ABC company is currently trading at $16 per share. When writing covered calls you generally want to sell call options that are slightly higher than you anticipate the stock to go.
When selling covered calls you ultimately want to try to keep ownership of the stock so that you can repeat the same process and collect the premium for selling the call options month after month or week after week.
If ABC is currently trading at $16 we would want to sell a call option with a strike price greater than $16 dollars. Keep in mind that the higher the strike price is above the current stock price, the less that option is worth and the less you can sell it for.
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