Many investors begin selling covered calls as a way to generate additional income from stock positions that they already own. When an investor decides to sell covered call options what they are essentially doing is selling another investor the right, but not the obligation, to buy shares of stock that you already own at a certain price (known as the strike price) on, or before, a certain date sometime in the future (known as the expiration date).
As compensation for selling the right to buy shares of your stock the investor gets a cash premium deposited immediately into their brokerage account. This deposit is cash and can be used for whatever the investor wants including reinvesting all of it, reinvesting a portion of it, or even withdrawing it. It is this cash premium that makes selling covered calls so financially lucrative.
So what are they ramifications of writing covered calls? If the market price of the underlying stock is below the strike price after the stock market closes at expiration the call option that the investor sold will expire worthless. In fact, more than 75% of all option contracts that are held until the expiration date will expire with no value. In this scenario, the investor would continue to own their shares of stock as well as the premium income they were paid for selling the option.
As long as the price of the underlying stock does not decrease significantly over the short-term, this trade will produce rather nice investment yields. This also serves to increase the overall return on this investment by reducing the cost basis of your stock. Every time the investor sells another call against this position their cost basis is further reduced.
If the market price of the underlying stock is above the strike price at expiration chances are that the investor will be ‘called’ out of their stock. Essentially what this means is that you stock broker will automatically sell the required number of shares to the buyer at the strike price. Most online brokers will execute this transaction for you so you need not worry about the mechanics behind the trade.
When an investor is called out of their stock they receive cash equal to the price of the underlying stock times the number of shares involved in the transaction. It is important to remember that the investor still gets to keep the premium income they received for selling the call option.
Selling covered calls is widely considered to be among the most conservative investment strategies available. They are considered so safe, in fact, that this technique is even allowed inside an investor’s individual retirement account.
Investors will write covered calls for any number of reasons yet a few of them are most common. The majority of covered call writers do so simply to earn the premium income. They care nothing about the underlying stock, the fundamentals of the company, or even the direction of the stock price. They engage in these transactions solely for the money they can earn. It is, in fact, extremely common for a covered call trade to produce yields of 3 to 5% per month while the rest of the market remains neutral or even declines somewhat.
Other investors will start writing covered calls on stock that they have in their portfolio that have remained stagnant over the past three to six months. The theory is that they should be able to earn additional income by renting their stocks to speculators. Doing so sure beats earning nothing from your shares of stock.
When executed properly, selling covered calls can enable the investor to generate higher investment gains with less risk from their existing stock positions.