Monday, November 22, 2010

Using Covered Calls

When the stock market is volatile, I like to sell covered calls as part of my trading strategy. For reference, selling a call obligates me to sell the underlying stock at a specific (strike) price. The buyer of the call purchases the right to buy the underlying security at a specific (strike) price. When a call is covered, the seller owns the underlying stock.

Covered calls provide me the following benefits:

  • A premium over the sale price. For example, if a stock is at $55, I can sell a $60 call for a $1 premium. If the stock is at $60 or higher at the call expiration date, I will receive $60 for the stock. Total sales price equals $60 strike price plus $1 premium or $61.
  • Earnings during a sideways trend. Using the same example, if the stock is under $60 on the expiration date, I keep the stock and the $1 premium for the call. Thus, I earned $1 while waiting for the stock to reach $60.
  • Insurance against a decline. For example, if a stock is at $55, I can sell a $45 call for $10.50. If the stock closes above $45, the totals sales price will be $55.50 ($45 strike price plus $10.50 call premium). If the stock falls below $45, I keep the stock and the $10.50 premium.
  • To get these benefits, there is an opportunity cost for using covered calls. I forgo any gains above the strike price since I am obligated to sell at the strike price. For example, if I sell a $60 call and the stock advances to $80, I am still obligated to sell at $60 and, therefore, do not get the $20 gain above $60.

    Hence, I prefer to use covered calls at short term highs when a stock is in a sideways trading channel. Thus, when the stock pulls back, I keep the call premium, wait for the stock to rally, and start the cycle again.

    For more on Strategies and Plans, check back every Monday for a new segment.

    This is not financial or investing advice. Please consult a professional advisor.

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