I like to show investors not only how to make money in the markets, but also how to use leverage to maximize their return on investment (ROI). Often it requires embracing new methods.
Here, I discuss a profitable weapon to add to your investing arsenal: the covered call. I compare the pros and cons of this strategy and when it’s the most appropriate.
I elaborate on all of these points, in my embedded “training video” below. Next issue of Power Profit Trades, I will provide a specific example of a covered call opportunity for you to act on.
The covered call can potentially generate extra income over and above the conventional buy-and-hold tactic – but only under the right circumstances. Let’s get started.
With this strategy, you own stock and you’re selling the right to buy your stock at a specific price on or before a specific expiration date.
To execute a covered call, you first have to own stock or buy stock. Your stock may or may not be bought. To give someone the right to buy your stock, you sell a call option. A call option is a contract that gives the buyer of it the right to buy stock at a certain price (strike price) on or before a certain date (expiration).
One options contract is the right to 100 shares of stock. For you to undertake a covered call strategy in your account on a stock you own, you must hold at least 100 shares of it. If you have 158 shares of stock you can only initiate one contract, because there are no contracts for 58 shares or .58 of a contract.
The term “covered” means you “own” the stock. When you sell the call option you must wait until someone in the marketplace exercises their right (the option) to buy your stock at the strike price or expiration.
“Called out” of your stock is the term for when your stock is bought away from you.
This would happen if the stock went high enough above the strike price that someone deems it better to execute the purchase of your stock at that lower strike price, versus the current market value of the stock.
Example: You sold a 50 Call against your 100 shares of stock and the stock goes to $57. Someone may think it is a better value for them to exercise their right and buy your stock at $50 instead of $57 per share, even if they paid $2 for the option right to do so. The $52 cost ($2 for the option + $50 for the stock = $52) versus market price of $57 still gives them a profit.
If you aren’t called out and expiration comes and goes, you get to KEEP the premium for which you sold the call option. In the above example, you would keep the $2 times 1 contract or 100 shares, equaling a profit to your account of $200.
The great thing about this is you get to keep that money, plus you get to keep your stock. You can look at the next month or further out and decide if you want to put your stock up for sale again and get paid to do it … again!
“Covered Calls” Can Be Expensive
Why? Because it involves owning stock – at least 100 shares, to be precise. If you already own stock and you don’t mind if it gets bought from you or not, this may be a way to generate additional income on a monthly basis.
But think about that last point: If you don’t mind the stock getting bought from you. If you inherited that stock or got it as a gift when you were a child and you know someone somewhere would be very disappointed if you sold that stock or you truthfully would rather hold on to it for the long haul, DO NOT undertake the covered call strategy, because you could get the stock called away from you.
Let’s also consider cost. As a case study, look at a hypothetical situation with Amgen Inc. (NASDAQ:AMGN). For a covered call on AMGN as a cash flow strategy, you’d have to buy at least 100 shares of the stock. The price of AMGN at the close on July 6 was $154.50, so a minimum of 100 shares would cost $15,450.
Now write a covered call. The term “write” when it comes to the markets means “sell.” Writing covered calls means to sell options on stock you own. If you don’t own the stock and you sell a call, it’s considered an uncovered position or what the market calls a “naked” position. Stay covered; it’s less risk.
To reiterate, your cost for owning 100 shares in this scenario is $15,450, which allows you to write a covered call on the 100 shares for whichever month you like. Since we’re looking at this as a cash flow position, our time frame will be roughly a month out.
Using the July Week5 expiration, one could sell the $155 Calls for $4.08. What does that look like to the account? For one, take the cost of 100 shares of AMGN $15,450 and take in for the sale of the option contract $408, and your cost basis in the stock is reduced to a cost of $15,042.
Or look at it this way: You bought the 100 shares at $15,450 and took in for the sold calls $408. This gives you a return for about a month of 2.7% (beats a bank CD).
Risks and Rewards of the Covered Call Trade
Consider the following possibilities that can occur to the covered call trader:
- The stock price stays flat or moves up a bit, but not enough to risk getting called out.
- Pro: This works out so that your sold option expires and you keep the premium as well as the stock, and look to repeat the process to go for another covered call paycheck maybe next month. Hypothetically with this example, 2.7% a month adds up.
- Con: The stock could drop significantly on you. You still get to keep the premium of the option sold, but what good is a 2.7% ROI from the covered call strategy when your stock is down 30%-40% in value? You have to spend a lot of time trying to get that stock up to break even and that includes writing covered calls each month to do so.
- The stock rises above the strike sold and you get called out of the stock.
- Pro: Depending on what you paid for the stock and the strike price sold, you could obtain a profit on the stock earning money for that and keeping/making the premium on the call option sold.
- Con: The stock you bought for $154.50 and sold a $155 strike call for $4.08 goes up in price starting the next day. You get called out on AMGN. This is an “opportunity risk.”
Under this last point, you made $408 on the option plus the gain in the stock of $50, for a total profit less fees and commission of $458. However, the stock over the ensuing days goes to $172 and unless you buy back into the stock, you miss out on all that upside profit.
The key point is to find a stock that you feel okay with selling if it comes to that. You’re looking to do the covered call for extra income over and above just selling it outright. If you get a month or two more of opportunity to do this with the stock, all the better.
For even greater detail about the covered call strategy, play my explanatory video below.
I continually strive to educate you on more than one way to pull money out of the market, to give you the flexibility and opportunity to make money under all market conditions – even when the markets are as turbulent as today. The conventional buy-and-hold strategy is too myopic and limits your ability to build wealth.
Next issue, I’ll provide a specific covered call play that’s on my radar.
Until next time,
America’s #1 Trader