WRITING COVERED CALLS

I prefer to begin discussions about learning various option strategies with Writing Covered Calls because it is easy to understand and because it will feel natural to stock market investors.

First, a definition: A covered call is a position consisting of two parts:

·         Long (that means you own) 100 shares of stock.

·         Short (i.e., you sold) one call option whose underlying asset is that same stock. 

WHY BEGIN WITH THIS STRATEGY?

Although it is not true for every new option trader, most people who come to the options world have some prior trading experience -- specifically, buying and selling stock. Writing covered calls is an extension of that investment strategy. I recommend beginning an options education with this strategy for one basic reason: It is a natural extension of something that most new option traders are already familiar with (buying stock).

That makes it much easier to glide into using options.

This is not the appropriate space to talk about whether an individual investor is better off choosing individual stocks or sticking with index funds or specific exchange-traded funds (ETFs).  I have a deep dislike for traditional mutual funds because of their steep sales charges (loads and/or redemption fees) and excessive management fees. If you are someone who already invests in individual stocks, then the strategy described below is likely to be very useful during the early stages of your options-trading career.

STRATEGY DESCRIPTION

Covered call writing (CCW) is a method for reducing risk associated with owning stock. Stockholders may earn a very large profit when the stock price soars, but they are subject to large losses when the stock price tumbles.

If you prefer to hedge that downside risk, then selling (writing) one call option for each 100 shares of stock owned is an efficient hedging method. 

WHY IS A COVERED CALL A HEDGED POSITION? 

As a reminder, when you sell a call option, the buyer is granted the right to buy your stock (at the strike price) at any time before the option expires.

Therefore, if the stock is trading above that strike price when expiration arrives, the call owner will exercise her rights to buy the shares, and you are obligated to sell. Profits are limited because you cannot sell your stock at any price higher than the strike price as long as you remain short that call option. In other words, you sacrificed the possibility of selling stock at a higher price in exchange for the cash premium that you were paid when selling the call.
Is that a good trade-off? I cannot answer that question for you. However, if you prefer to hold stock. waiting for a higher price, then this is not an appropriate strategy.

When an investor owns 100 shares of any stock, there is only one way to earn money, and that is for the stock price to increase.  Reality tells us that our expectations do not always come true. Thus, if you want to hedge your stock position you can sell one call option to create a covered call position. Why would you do that?

·         You keep the option premium no matter what happens. Therefore you are paid to own the shares. You may look at this as a way to reduce the cost basis of your investment. 

·         If the stock does not move higher than the strike price, you earn an extra profit that no other stockholder earns. That profit is the option premium (cash paid to you when selling the call option). If the stock price declines over the lifetime of the option, they the loss is cushioned (or eliminated) by the amount of premium. These are very appealing attributes for investors.

·         You may choose the strike price of the option sold. When you choose a higher strike price, you have the opportunity to earn a better profit (capital gain on the shares), but the premium is lower. If you sell a call option with a lower strike price, you earn a higher premium, but if the stock is sold at the strike price, the capital gain is smaller.