Many investors find it very challenging to receive a steady return from their money invested in the stock market.
Program: One widely used strategy within the stock market investments by investors is using covered calls which involves selling of call options from stocks they hold.
Solution: This article will break down the concept of covered calls. It explains why investors love the strategy and how it can bring a steady income stream while it may limit some downside risk.
What is a Covered Call?
A covered call is one of the options strategies whereby an investor holds a long position in a stock and sells call options on the same stock to generate income. Such a strategy is known to be “covered” since the underlying stock owner who sells the call option reduces his or her risk from selling the call.
Why Investors Love Covered Calls
Steady Income: Covered calls offer a steady income stream. When selling call options, investors receive premiums, which can be received on a weekly, monthly, or annual basis, depending on the contract terms.
Risk Mitigation: The income from selling call options can help offset potential losses if the stock price declines. This makes covered calls a relatively safer strategy compared to other options trading methods.
Flexibility: Investors can be flexible in selecting the strike price and expiration date of the call options they sell, thus being able to make the strategy align with their needs and expectations and market outlook.
How to Implement a Covered Call Strategy
Pick the Stock: Pick a stock that you feel will be relatively stable or rise by some percentage in the short term. In other words, pick a fundamentally sound stock to limit the chances of significant price falls.
Buy the Stock: Buy at least 100 shares of the stock that you have chosen because options contracts are for 100 shares.
Sell the Call Option: Sell a call option at a strike price higher than the current stock price. The premium collected from selling the call option is your income.
Manage the Position: Track the position until the expiration date. The call option might be exercised or expire worthless depending on the stock’s performance.
Real-Life Example: Intel Corporation (INTC)
To explain how covered calls work, let’s use an example of a real-life application using Intel Corporation (INTC).
Scenario Setup:
Current Stock Price: $32 per share
Call Option: $34 strike price, expires in two months
Premium Received: $1.50 per share
Scenario 1: Stock Price Declines
It will not be exercised at the call option because the option buyer will not spend their money to purchase the stock at $34 when it is available in the open market at $30. The investor retains the $1.50 premium that offsets part of the $2 loss per share on the stock.
Scenario 2: Stock Price Remains Unchanged
If the stock price stays at $32, the call option will not be exercised again. The investor keeps the $1.50 premium, which is a 4.6% return on the stock over two months, annualizing to a 28% return.
Scenario 3: Stock Price Increases Slightly
When the stock price appreciates to $33, the call option will not be exercised because the strike price is $34. An investor would thus reap the benefit of a $1 increase in stock price and add to it the premium of $1.50, netting a total of $2.50 per share.
Scenario 4: Stock Price Surges
If Intel’s stock price soars to $40, the option buyer exercises the call option, purchasing the stock at $34. The investor makes a profit of $2 for the stock, plus the premium of $1.50 for a total profit of $3.50 on each share. The investor gives up the excess upside as the stock is sold at $34 instead of the $40 the stock actually trades at.
Critical Variables in Covered Calls
Strike Price: The strike price defines the amount at which the underlying stock has to be sold if the call option is exercised. High strike price positions offer a higher potential upside but result in a lower premium.
Expiration Date: The duration of the call option impacts the premium. Higher durations give higher premiums but lock down the terms for a longer time span too.
Optimizing Covered Call Strategy
Short-term compared to long-term options: One can sell the short-term call options repeatedly in order to accumulate higher total premiums; however, that may lead to lower premiums when the stock price drops. The longer-term option to sell brings more certainty into premium collection, but it puts a limit on flexibility.
Choose the Strike Price: The strike price needs to be balanced so that it maximizes income while at the same time permitting reasonable stock appreciation. A lower strike price generates a higher premium but caps the upside, while a higher strike price offers more potential gains but lower premium income.
Covered calls are indeed a strong, steady-generating income source when investors invest in stock while keeping down the risks associated with investing in stocks. Having knowledge about what strike price to choose and on what expiration date will enable this strategy to better fit individualized financial objectives. The limiting potential for profit increase is countered, however, with the predictable selling of call options that yield constant income for a covered call approach.
This will enable new users in options trading to first of all understand call options before starting off into covered calls. With proper guidance, the cover calls would bring forth and improve investment techniques and allow them to achieve income generation with guaranteed returns from stocks in the market.
