The Risks and Rewards of the Covered Call Strategy

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!

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How to Profit on a Stock that Goes Down in Price

For some investors, it seems counterintuitive that you can make money on a stock that goes down in price. Those folks most likely haven’t heard about options trading or if they have, never pursued it to the point of understanding.

To illustrate my point, I will show you a Put trade, specifically a Buy Put (or long Put) trade on SunEdison (NYSE:SUNE). It was a Money Calendar Sell candidate that turned out well for us. This sort of trade is particularly relevant right now, as world markets post consistent declines.

I also explain this trade in greater detail in my training video below.

First, let’s look at the latest bearish signals for SUNE as depicted in the Money Calendar:

You buy Puts when you anticipate a stock will go down in price. When you buy a Put option, you have bought the RIGHT to “Put” or sell the stock to the marketplace at a specific price (the strike price) any time before or on expiration.

Example: XYZ stock is trading at $40 and you buy a $40 Put option for $2 (this is on a one contract basis, so the cost would be $200 for the option).

Next the stock goes down to $35. You have the right to “Put” or sell the stock to the marketplace at $40 when the stock is at $35. To do that, you would have to buy the stock at $35 and then exercise your right and sell the stock at $40, resulting in a $5 gain. This gain would be offset by the cost of the option price of $2, so you would gain $3 per share.

But we do not buy options to exercise our right on the stock.

When the stock is at $35, it would result in the option being considered “In the Money” or having “Intrinsic Value.” Think of it this way: The stock is at $35 and the $40 Put means it could result in a $5 gain on the stock transaction – it’s a “built in” profit potential of $5.

That $5 will be reflected into the price of the option, because options are comprised of two components that go into their price: Intrinsic Value and Time Value.

If the option you paid $2 for is now at LEAST $5 (not including any time value to make the math/illustration easier), you have a $3 gain on the option trade. Making $3 on a $2 investment is a great return!

Here is the action I previously showed for opening the SUNE trade:

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