A common misconception about options is that options are too risky and suitable only for the speculative investor. Although options can be used for speculating, the truth is that options are often utilized to minimize the risks associated with investing.
One of the most basic and widely used options strategies is the covered call. Employed correctly, a covered call can potentially increase profits and limit losses simultaneously.
A covered call strategy can be entered at the time a long stock position is established (buy/write) or can be written against a stock position already held by an investor. In general, one call option is written/sold for every 100 shares of stock owned. The covered call writer receives income for selling the call but will be obligated to sell the stock at the call’s strike price if assigned, thereby capping further upside stock price participation.
Covered calls are for an investor who has a neutral to moderately bullish view of a stock and who wishes to generate income in addition to any dividends from shares of underlying stock owned. While covered calls are a great way to generate income in a flat or mildly up-trending market, the limited risk protection that covered calls create should not be overlooked. However, the protection is limited to the amount of the premium received from the sale of the option.
When writing a covered call, it’s best to sell options with a strike price slightly greater than the current stock price. If the stock remains flat, declines in value, or moderately increases in value, an out-of-the-money call option will likely expire worthless and the investor will keep the premium received from selling the call options. If the call option expires worthless, you can do it all over again!
Although this strategy may not be suitable for everyone, it can provide a stock-owning investor limited downside stock price protection in return for limited participation on the upside.
Contact your Wealth Advisor for more details.
Although waiting until expiration will maximize your return on an out-of-the-money option, you are not required to do so. An investor can close out a covered call option at any time by buying it to close at the current market price. In addition, a significant increase in the price of the underlying stock prior to expiration could result in an early assignment of the covered call option.
If, on the expiration date of the option, the stock is trading above the strike price, an investor will likely have their stock called away at the strike price. This isn’t necessarily a bad thing and will likely result in a profit. The investor keeps the premium from the sale of the call option and profits from the appreciation of the stock up to the strike price written.
Keep in mind that a covered call strategy is not a risk-free profit opportunity. Rather, it is simply a means to generate additional income from underlying stock owned at the expense of foregoing unlimited upside potential.
Example:Let’s assume you buy 500 shares of ABC stock at $73, and sell 5 ABC January $80 calls at $2. Since you received $2 for the covered call, it provides $2 of immediate downside protection. $71 will be your new break even price on the shares of ABC stock, $73 purchase price minus $2 premium collected.
The tradeoff for this strategy is that the upside profit potential is limited above $82, $80 strike price plus $2 premium collected. If you expected the price of ABC to exceed $82 by the January expiration date, the stock purchase alone would have been more profitable than the covered call strategy.
Please Note: Commissions, dividends, margins, taxes, and other transaction fees have not been taken into consideration. However, these costs can have a significant effect on expected returns and should be considered. Please consult a tax advisor for the tax implications involved in these strategies.
Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options (ODD). Copies of the ODD are available from your Wealth Advisor.
Securities and advisory services offered through J.J.B. Hilliard, W.L. Lyons, LLC, a registered investment advisor and broker dealer. Member NYSE, FINRA & SIPC. Investing in securities involves risk, including possible loss of principal. ©2016. All rights reserved.
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