Making Money On Covered Calls
I learned of this technique a couple years ago. It involves writing covered calls. A call is an option or derivative. If you don't understand what an option or derivative is, then do some more research online and/or read my article on options investing.
When someone says they are "writing a call", this means they are creating an call option contract and selling it to someone else who wants it. It is a contract between the writer and the buyer that guarantees the buyer, that the writer will sell him a set number of shares (100 shares per option) at a fixed price up until a specified expiry date if he chooses.
For example:
I can write/sell 1 March $25.00 call on Nortel shares for $0.15 a share. Since there are 100 shares in call that means the buyer would have to pay me $15 for it. I am guaranteeing him, that I will sell him 100 Nortel shares at $25.00 a share at any point until the end of March if he wants me to. If he never does, then the option expires at that point. So he is paying me $15 for that option.
The concept of how options works is sometimes confusing. I basically think of it as buying and selling a type of insurance on stocks. You may be willing to pay the price to buy the option of getting a stock at the price you want sometime in the future. A put is similar, but for selling.The "covered" part of a call means that you already own the shares you are writing the call for. Not covered, or naked, means that you don't own the shares. If the buyer wishes to exercise his option, you will be forced to buy the stock at market price and then sell it to him at the option strike price ($25 in the example above). You also need to have "margin" available to cover the difference you might be out if the stock price goes higher and you will be forced to buy the stock at a higher price then you will be selling it to him. When you are covered you don't have this risk.
How Do I Make Money On This?
Your goal is this: you want the stock's price to not go higher than the strike price of you option. If it doesn't go higher than this, no one will exercise the option because it won't be worth any money. They can buy the stock for cheaper off the open market. This way, you pocket the money you sold the option for and you can then sell a new one.
The trick here is to sell an option that is in your comfort zone. If you are scared the whole time that the buyer will exercise on you because the strike price is too low, then don't bother. You will have sold it for more money, but if you don't want to be exercised than you shouldn't run that risk.
Why Would I Want to Do This?
You own a stock, you don't want to sell it right now, but you don't see it going up in the short term. Options can expire anywhere from 1 month to 6 months in the future. If some bad news has come out or for some reason you think the stock will stay flat or go down (like oil companies in the summer can sometimes do) then selling a call might be a good choice.
What Are The Risks
If the stock decides to go on a run then you will be forced to sell the stock or buy back your option for more money. You will be out either the appreciation in the stock minus what you sold your call for or you will be out the amount you had to buy your option back for minus what your call for.
My Thoughts On It
I have tried this technique and to tell you the truth, I haven't made any money on it overall. I had some Nortel shares I bought in 2001 that had gone down and look they would never go up so I was just selling covered calls on them. I would make money on most of them, but then Nortel would take a run and I would buy them back at a loss. Unfortunately that one loss was enough to offset the 4 gains I had before that.
I still believe this is a useful technique though, but there are few things to note.
- It requires that you pay very close attention and watch the markets frequently. If your stock takes a run and you don't notice for a few days you could be hurting.
- Don't be afraid to get out as soon as you are sitting at a small loss. Too many times people let their emotions get in the way and hold on because they don't want to take a loss on a option (or a stock for that matter).
- Don't mess around with volatile stocks unless you have the nerve. These are the ones that pay really well, but there is a reason for that. They are volatile, the risk and rewards are greater. This being said, if you do the math, these are usually the only stocks that give you decent returns if you want to use covered calls for a high rate of return. I would just be happy to make my $100 every couple months on a slow mover and be safe, but that is my opinion.
- If you think the stock is going to tank, just leave your call and sell your stock (if your trading account won't let you have uncovered calls you will need to buy it back). Most of your money is tied up in the stock and this is where your biggest loss will be, so sell it if you need to.
How Should I Start?
Read up some more. Here are some useful links.
- Montreal Exchange - This is the site the handles option trading in Canada. You can get quotes and such here.
- Investopedia's Options Basics - This site always has tidbits to teach you.
- Nothing But Options - I like there examples here. Helps to get the idea on how options work.
- Finance - Yahoo - There finance pages give you access to quotes for all the American stocks.
Paper trade for the first while. Pick a stock you own, look up the current price to sell a call for it, and write that number down. Also write down what your commissions would have been (check your brokerage's rates). Keep an eye on it to see how it moves. It will decrease in value as time decreases, but will also go up and down with the price of the stock. If the value of the option becomes worth less than what you sold it for by quite a bit then "pretend" to buy it back or you can let it expire if the stock price never goes above the strike price.
After you can paper trade and make money 4 out of 5 times. Think about getting an account approved for covered calls and try your hand on small amounts for awhile. After that, its up to you.
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