The Covered Call



Do you think the only way to make money on a stock you own is by price appreciation or dividends? If so, you would be wrong. Covered call writing can allow you to generate income from stocks you hold in your portfolio by selling someone the right to purchase your stock at a certain price. Let me explain.


Description:

A call is written against a long position in a security on a one-to-one basis and is for a defined period defined by the expiration date. Maximum gain is limited to the premium received, plus the increase in the security price up to the call's strike price. Maximum loss is substantial (premium received less the strike price).


Why use this strategy:

Traders may typically use this strategy to generate income beyond any dividend received when the outlook on the underlying security is neutral to moderately bullish. Some traders also use it as a way to sell or target an exit price for a position.


First, let me start by letting you know that I am not a stockbroker. Stock options trading involves a risk level that you should review with your registered investment adviser, broker-dealer, and tax accountant. As a matter of fact, before you can trade options, you must be approved to do so by your brokerage institution. You will be required to read Characteristics and Risks of Standardized Options, which will provide you with extensive material to consider before buying or selling your first options contract. This discussion is for educational purposes only and not investment advice. It will cover some of the basics of options and one of the strategies I have used over the last 30 years to enhance my portfolio's returns. Specific securities are mentioned for informational purposes only and are not presented as investment advice.

Here is a recent trade from my own account:


On 1/21/2021 I sold one covered call on 100 shares of Apple stock (ticker symbol AAPL). Remember, each stock options contract controls 100 shares of the underlying stock. In this case, I sold someone the right to purchase my 100 shares of Apple stock at $130 a share by the expiration date of 2/19/2021, the financial shorthand for this option reads like this:


1 CALL (AAPL) APPLE INC COM FEB 19 21 $130 (100 SHS)


Translation - 1 contract, a call option, the underlying stock is Apple (AAPL), contract month is February 2021, the expiration date is February 19, 2021, the strike price is $130 and the option contract controls 100 shares of the underlying Apple stock.


I originally purchased the 100 shares of Apple stock on August 31, 2020, for $128.24 per share. The options premium from the sale of this covered call on January 21, 2021, less a small commission, was $597.29.


The option expired on February 19, 2021, at the close Apple stock was trading at $129.87. This means that the option expired and was not executed because the stock price was below the strike price. In other words, why would you pay $130 for something worth $129.87? As a result, I keep the original premium paid to me for the option, $597.29.


The beauty of this is that I'm free to sell another covered call with a different contract month and strike price and continue to generate income on my 100 shares of Apple.

Glossary:


Covered call - A covered call is a financial market transaction. The seller of call options owns the corresponding amount of the underlying instrument, such as shares of a stock or other securities.


Expiration date - The expiration date for listed stock options in the United States is normally the third Friday of the contract month.


Premium - The income received by the seller (writer) of an option contract to another party.


Strike price - In finance, an option's strike price is a fixed price at which the option's owner can buy or sell the underlying security or commodity. It is also known as the exercise price.



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