I receive a lot of emails.
My favorite questions are about trading. Over the weekend, a reader responded to an article about the importance of covered calls. As I noted, the Relative Strength Index (RSI) on the SPDR S&P 500 ETF (NYSEArca: SPY) hit overbought territory last week. Typically, I prefer to sell calls on existing positions when we reach an RSI over 70 on the SPY.
They wanted to know about the strategy, the critical components of the trade, and what they present to investors and traders. Today, I’ll explain covered calls and how they can help you boost returns and manage risk. Let’s dive in.
What’s a Covered Call?
Covered calls are considered a conservative trading strategy. An investor sells a call option on a stock that they own. So, anyone with 100 shares can sell one contract to another investor or trader. When we use the word “covered,” we’re talking about the investor owning the underlying stock. When you sell the call, it acts as collateral for the position.
When you sell a call option, you give another trader the right, but not the obligation, to buy your stock if share prices increase to a predetermined price (strike price) within a specified time frame (expiration date).
So, let’s consider a scenario where you own 100 shares of Ford Motor Co. (NYSE: F), the auto manufacturer. If you own 100 shares of the stock (currently trading at $10.30), the value of your position is $1,030. That’s the first step in starting this trade.
It’s important to note that if the stock declines after you sell the call, you’ll still own it. It’s only if certain events happen that you would be required to sell the shares to the buyer of the option.
When you sell the call option on the stock, you’ll sell a specific contract for a predetermined strike price on a particular expiration date. So, let’s look at various examples of strike prices and dates of expiration. Below is the options chain for Ford at two specific expiration dates.
For example, the $12 call for February 16, 2024, currently trades for $0.15.
But the $12 call for March 15, 2024, trades for $0.21.
That additional six cents is linked to the option’s time value, an essential piece of terminology. So, if you own 100 shares of Ford at $10.30, you can decide the better amount of money to generate. Do you want to sell and wait until March, or look to a price target sooner? In addition, consider selling the $11 call, given that it can generate an investor $45 instead of $21 on the $12 call.
The money that investors receive for selling calls is called the option premium. In exchange for selling the call option, the investor receives a premium from the buyer. This premium is essentially income for the investor, regardless of whether the option is ultimately exercised.
What Outcomes Can Happen?
There are three different outcomes in this sort of trade.
Suppose you sold the $12 call for March, but shares never reach that price. In that case, the option buyer would never exercise the option and take delivery of the shares. The seller gets to keep 100% of the profit and still owns the underlying shares.
The second scenario is that the stock moves above $12, and the option buyer exercises the contract. The seller receives $1,200 for the 100 shares and keeps the premium. It’s important to note the strike price at which investors will sell the stock. They don’t get to keep anything above that level besides the option premium.
The final scenario is that the stock pulls back. The sale of those contracts is a form of protection against the downside. If an investor plans to keep shares for the long haul, the continued selling of call options can generate income repeatedly.
Trading covered calls can be one of my favorite strategies as an investor.
It allows me to pick a price at which I’d be willing to sell, and I can generate income and protect my portfolio.
As with any investment strategy, it’s essential to conduct thorough research, assess individual risk tolerance, and stay informed about market conditions to make smart decisions in the ever-evolving landscape of financial markets.
Over at Tactical Wealth Investor, I’ll teach my subscribers how to use covered calls next week, and the opportunities to generate income from already significantly discounted stocks.
*This is for informational and educational purposes only. There is an inherent risk in trading, so trade at your own risk.
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CFTC Risk Disclaimer:
Trading in financial markets, including but not limited to futures, options, and foreign exchange, involves substantial risk and is not suitable for every investor. You should carefully consider whether trading is suitable for you in light of your circumstances, knowledge, and financial resources.
Past performance is not indicative of future results and that there is a substantial risk of loss in trading commodity futures, options, and off-exchange foreign currency products. You should be aware of the risks associated with trading and seek advice from an independent financial advisor if you have any doubts.
Hypothetical or simulated performance results have certain inherent limitations. Unlike an actual performance record, simulated results do not represent actual trading. Also, since the trades have not been executed, the results may have under- or over-compensated for the impact, if any, of certain market factors, such as lack of liquidity.
No representation is being made that any account will or is likely to achieve profits or losses similar to those shown. The information and strategies on this advertisement are for informational purposes only and should not be considered as financial advice.
CFTC RULE 4.41:
Hypothetical or simulated performance results have certain limitations. Unlike an actual performance record, simulated results do not represent actual trading. Also, since the trades have not been executed, the results may have under- or over-compensated for the impact, if any, of certain market factors, such as lack of liquidity. Simulated trading programs, in general, are also subject to the fact that they are designed with the benefit of hindsight. No representation is being made that any account will or is likely to achieve profit or losses similar to those shown.