In the stock market today, investors have more choices than straightforward purchases of stocks, bonds or mutual funds. Strategies such as shorting stocks and the buying and selling of options can increase returns or minimize losses, but also carry risk.
There is a particular strategy of selling covered calls which can generate significant income in some markets, but can also lead to substantial losses, or cause the investor to miss out on large gains.
Definition of Stock Options
There are two main types of options, a call option and a put option. Charles Schwab & Co. defines a call option as “a contract that gives the holder the right to buy the underlying security at a specified price for a certain, fixed period of time.”
Generally, buying one option gives the purchaser the right to buy 100 shares of a stock. If the stock price exceeds the intended price (known as the strike price) the option can be exercised and profit made on the difference between the current price and the strike price.
As long as a market exists for the option, it can be bought or sold any time until it expires. Options not sold or exercised become worthless at expiration.
It is possible for an investor to be either a buyer or a seller for a call option. Selling naked calls means that an investor will sell an option without owning stock to offset the option. This is a very risky strategy and is not often available to the individual investor.
If an investor sells a naked call against a stock that rises significantly over the strike price, the investor will owe 100 times the amount of the difference. A safer strategy is to sell covered calls, where the investor owns the underlying stock, and sells the call option.
Options are right to buy stock in the future, and the prices of stocks fluctuate. In order to account for this, a call option is priced at a premium, and that premium declines as the expiration date nears. An option due in one month will be worth more today than tomorrow, if the price remains unchanged.
For example, if XYZ stock is priced a $41 today, a call option to buy XYZ at $40 in one month might be priced at $3. One dollar is the difference between the current price and the strike price, and two dollars is the premium to account for price fluctuation. This amount is multiplied by the number of shares that the option represents, generally 100.
Pros of Selling Covered Calls
- The seller receives the price of the call, in this case $300, immediately on the date of the transaction. If the price remains above $40, the seller will realize $2 profit from the premium and the option will be exercised. At this point the stock is sold.
- If the price declines below $40, the option will not be exercised. The seller will keep the $300 sales proceeds, and will also retain the stock.
- If desired, the seller can buy back the call before expiration. If the price has declined, the seller may wish to reduce the risk that any more fluctuations will occur.
Negatives of Covered Calls
- If the stock price rises well above the strike price, the seller does not enjoy the increase, as the seller’s profit is limited to the $2 premium.
- The option seller cannot sell the underlying stock without first buying back the call option. A significant drop in the price of the underlying stock (greater than the premium) will result in a loss on the entire transaction.
- Commissions are charged on every part of the transaction. On initial purchase of stock, the initial sale of the option, the sale of the underlying stock at expiration, or the buyback of the call option.
- Premium amounts are based on the historical volatility of the underlying stock. A stock with a higher premium will carry greater risk of price fluctuation.
Selling covered calls is a strategy to generate income that carries considerable risk of loss on the underlying stock and foregone appreciation. It can be a valuable strategy as part of an overall balanced portfolio.
