Investing 101: Covered Calls
Most investors do not understand how to generate cash flow from their stock positions. Covered calls can be used to hedge your stock positions. My stock advisory newsletter first introduced to me the strategy of covered calls. I was shocked to discover that even major IRA accounts ran by brokerage firms allow you to write covered calls because of its relative safety to other option strategies.
Covered call writing is usually easier than most people make it out to be. It works like this. I’ll give you $1,000 now, if you let me buy your stock five months from now at a set price. If I want to walk away from the deal, you get to keep my money.
With a stock, let us say I buy 1,000 shares of ABC OIL at $10 and the stock goes to $11 in the following month. I can sell someone the “right” or option to buy the stock from me six months from now at $12.50. For that right or option, the option buyer has to give me some consideration, similar to the above real estate example, let’s assume it is .50 per share or $500.
The cool thing is that I get the $500 immediately deposited into my brokerage account. The option position now shows up on my brokerage statement. I must not sell the stock prior to six months unless I buy back the option at the current market price. I usually hold my stocks until expiration because of how much the option price fluctuates from day to day.
Six months from now, two things can happen. First, the stock can go above $12.50 and the buyer of the option “calls” me out of the position which I happily do since I bought the stock at $10. The second thing that can happen is that the stock falls below $12.50 and the option holder is holding on to a worthless option. No option holder is going to “call” you out of the stock if it is $12.50 when he can buy the stock in the open market for $11.50 a share.
After the call expires, I then start all over again by writing another call again.
So let me back up. What exactly did I do here? First, I hedged my position by 5% or $500. Second, I set a strict target price that I was willing to let the shares go for, $12.50. Finally, I created immediate cash flow that I could use for my daughter’s birthday or reinvest.
This strategy has made me very happy in bear markets because most options expire worthless and I get to keep my stock and what the option buyer originally paid me for the option!
A good friend of mine is a computer programmer. He also shares a passion for covered call writing and has written a program that is in beta testing. I am his BETA Dummy. So far, the program has saved me countless hours of research and has narrowed my focus to a short list of 5-10 natural resource stocks to add to my portfolio quarterly. In future articles, I’ll discuss some of my picks and income generated from the covered call strategy, plus provide a link to the option software.
But remember, any option strategy involves more risk than just buying a stock so always consult with a licensed financial adviser first.
Do not buy any stock trading education materials until you see Lance Jepsen’s free stock market blog at how to invest in stock market, and learning the stock market
Tags: cash flow, finance, option position, option strategies, option strategy, Option Trading, relative safety, Stock Charts, stock market, stock positions, Stock Trading, Stock Trading, trading education
One Comment on “Investing 101: Covered Calls”
You made some good points there. I did a search on the topic and found most people will concur with your blog.