The Covered Call Option Investment Strategy and when to Use It

For many people simply buying a single stock is a risky proposition. Moreover, the options market can be equally as scary. If you enjoy investing and have not yet explored the world of options, then Covered Calls is one way to dip your toe in the water and learn. Covered Calls is the least risky of all option investing and the easiest to understand.

What is a Covered Call?

In simple terms you are renting your stock position to someone else. You still maintain ownership; they pay you for the right to exercise their option.

How Covered Calls Work.

First you must understand that option contracts come in 100 block shares. Each 100 shares equal an option contract. Let's say you have 100 shares of XYZ stock and you want to make a little "rent" on the side. You would simply sell an option contract on XYZ to another investor for a strike price typically above the current market price. We will assume the current market price for XYZ is $20 and you acquire 100 shares. You have now invested $2000 excluding commission. You now research the option chain for call contracts above your $20 price for XYZ stock. This is deemed "out of the money" call options as the strike price is above the current market price. You decide to sell a Call Option Contract (100 shares) to another investor at a strike price of $25 that expires in 60 days that pays you 0.30 per share. You retain ownership of your 100 share but authorize someone else to force you to sell if the price goes above $25 before the expiration date. They pay you immediately for the right to force you to sell. In this example, you will receive immediate income of $30 to your brokerage account. (.30 x 100 shares). That money is yours to keep.

What are the risks?

Once you execute a Covered Call Option, you will receive immediate income for the "rent" of your stock. Basically 2 things can happen. First, let's assume that the stock never goes above the $25 strike price in 60 days. You keep the money from the option ($30) and you keep your 100 shares of XYZ stock. You are $30 better off than not "renting" your stock. The second thing that can happen is that the stock goes above the $25 strike price and you are forced to sell. You again keep the $30 option revenue and you will also profit on the sell of your stock. ($25 - $20 = $5 X 100 shares or $500 excluding commission). You will have $500 + $30 profit. However, you are forced to sell at $25. The only consequence is if your XYZ stock skyrockets and soars to $40 per share. You are forced to sell at $25 and the owner of the option contract is a happy camper.

I recommend Covered Calls for investors that have long term horizons or long positions with their stocks. If you know you would sell the stock with a 20% profit, why not add some extra income along the way? If the stock does not move above the strike price, you continue to collect extra income on your money. Covered Calls is an easy way to venture into the option market and make a little extra juice with your investments.