There are several basic strategies that can be used by traders who are new to stock options that don’t involve a lot of risk. A common concern of many investors is that all option trading strategies are risky and will lose money. While there are plenty of risky option investments, there are also some relatively low risk strategies used to generate considerable profits if implemented properly.
The covered call strategy for example, is considered to be a low risk option trade that can generate a decent amount of cash from existing shares in an investors’ portfolio.
Let’s take a closer look into this option trading strategy.
Selling Call Options
For those that are not familiar with stock options, there are two different types. A call option gives the buyer the right to buy an underlying stock at a specified price within a certain period of time. A put option on the other hand gives the buyer the right to sell an underlying stock at a specified price within a certain period of time.
An investor who decides to sell a call option has a different goal in mind compared to the investor who buys options. If the option is exercised, then the seller has an obligation to sell the underlying stock at the strike price. In return for assuming this risk, the seller is paid the premium of the option which they are free to keep no matter the outcome.
What Does Covered Mean?
The term “covered” means that the seller (that’s you) can cover his/her position if the buyer exercises their option. For example, if you decide to sell 5 covered call options, then as the seller you need to own 500 shares of the underlying stock.
Selling a covered call is considered a low risk options strategy as you have the shares to back up your trade if you need them. The opposite of being covered is selling a “naked” option, which is much riskier. Selling naked options means that you don’t own the stock and would be required to buy it at its current price and sell it back to the buyer for the strike price.
Steps to Selling Covered Calls
There are a few important steps that you need to be aware of when selling covered call options. Here is an oversimplified list of steps an investor needs to take in order to successfully implement this basic options strategy.
- Buy the Stock – In order to be “covered” on your trade, you first must own the underlying stock. Remember that for every option contract you sell, you must own 100 shares of the stock. Your broker will not allow you to place the trade without these shares in your brokerage account. A broker will also require special approval in order to trade options, so a standard online brokerage account may or may not offer this feature.
- Find ‘Out of the Money’ Options – It is helpful to look for call options for your stock that are out of the money. A call that is out of the money will have a strike price that is higher than the current share price of the stock. For example, you may find an option for a stock with a strike price of $55 and the share price is currently at $50. This contract would be out of the money until the share price hits $55.01. Once that threshold is passed, then the option contract is considered in the money.
- Look for Soon to Expire Contracts – Another important step that can be used to limit your risk is to look for soon to expire call option contracts. Most investors who sell covered calls don’t actually want to lose the stock and would prefer it to expire without being exercised. Since options are time sensitive, the seller should look to limit the total time the option is open. It is a good rule of thumb to look at call options that expire no more than 2 months out.
- Analyze the Potential Trade – Even though you may have found a call option that is out of the money and expires in less than two months, it is important to analyze the trade. For example, if a potential covered call option trade will only net you $20, then it may not be worth risking your shares. Take the time to calculate how much you will profit from the trade and what would happen if your call option is exercised.
- Place the Sell Order – Once the analysis has been completed on the call option and the trade seems favorable, it is time to place the order. Work with your online discount broker to place a sell order to open transaction.
Possible Outcomes from Selling Covered Calls
Even though selling covered calls is thought of as a low risk option trading strategy, there are several potential outcomes. Most of the time, the results will depend on overall market conditions as well as the performance of the stock. If the stock does poorly, then there is a good chance the option will expire. However, if a stock performs well, then the seller may be forced to sell their shares.
Here are a few possible outcomes from selling covered calls -
- Option Expires Without Being Exercised – As the seller, you will profit the premium less any commissions and retain the stock. The buyer of the call will be out the premium paid to you the seller.
- Option is Exercised on or Before Expiration Date – The seller must sell their shares of the stock to the buyer at the strike price. They will receive the funds from the sale of the stock as well as keep the premium. The buyer purchases the shares and is out the premium paid for the right to purchase.
- Purchase Back the Call Option – The seller decides to buy back the call options to avoid losing the stock or in some cases to take profits.
Selling covered calls provides a tool for investors to generate extra income just from owning a stock. In return for earning this extra income, the investor is potentially risking their stock and may be forced to sell it for less than market value. Learning how to properly trade options takes time and practice. While the covered call strategy may not be as risky as others, it is still important to analyze the risks versus rewards for each possible trade.
If you would like to learn more about options and covered calls, then you can check out the Chicago Board Options Exchange strategies section for more details.
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