Investing in the stock market is a thrilling endeavor, but it can also be nerve-wracking. Volatility and uncertainty often make investors apprehensive about maximizing their potential returns. However, there is a clever strategy that allows you to mitigate some risk while still benefiting from the market’s growth – enter the covered call strategy. Let’s dig deeper into this clever approach and see how it can help you make the most of your investments.
Table of Contents
1. Understanding the Covered Call Strategy:
The covered call strategy involves entering a long stock position while selling call options on the same stock. In simpler terms, it means you own the underlying stock and sell someone else the right to buy that stock at a predetermined price (strike price) within a specified timeframe (expiration date). Sounds complex? Rest assured, we’ll break it down!
Pro Tip: For US equities, ownership of a minimum of 100 shares is a prerequisite for covered call selling. Meanwhile, across the pond with UK equities, the threshold is set at a minimum of 1,000 shares for participation in covered call transactions.
2. The Benefits of Covered Calls:
– Generating income: By selling call options, you earn upfront premiums, an upmarket alternatives platform, allowing you to generate extra income from your stock holdings.
– Reducing risks: The call options you sell are a buffer against downward price movements. Your stock’s premium cushions the potential loss, limiting your risk exposure.
– Enhancing portfolio performance: With the right covered calls, you can simultaneously enhance your portfolio’s returns by collecting dividends and call premiums.
3. Implementing the Covered Call Strategy:
To successfully implement the covered call strategy, you need to follow a structured approach:
– Select suitable stocks: Choose stocks you believe will have a stable or slightly bullish outlook.
– Determine strike price and expiration date: Select a strike price that aligns with your desired profit target and an expiration date that suits your investment timeframe.
– Execute the covered call trade: Sell call options against your stocks. Remember, you must sell the shares if the buyer exercises their right.
Here is a hypothetical example of a covered call and how it works:
Let’s use Joe as an investor who owns 100 shares of a company called ABC Mining that is trading at $50/share, This is the price he paid for his shares.
Joe decided to sell a call option at a strike price of $55/share, expiring in a month.
For doing this trade Joe receives a premium of $2/share into his brokerage account, typically the same day.
This translates to $200 in income, irrespective of the stock’s performance until option expiration. Sounds great doesn’t it?
Well, this is quite a simplistic view and one you will find written all over the internet, but this strategy is more nuanced than that and to understand covered calls better we need to look at other scenarios if the price of the stock trades around a bit.
So for example, if the shares end up at $55 or higher at expiration date then the call will be in-the-money (ITM) and that means it is likely to be exercised, meaning the shares will be called away (sold).
The owner of the call option will have the right to buy the covered call from Joe at $55 each. That’s no problem as Joe originally bought them for $50 and is now selling them for $5 more per share.
In other words, Joe has made a small profit and no loss on ABC Mining.
And Joe does have the $2 premium per share that was paid to him when he sold the covered call.
Here is Joe’s profit and loss for this trade:
100 shares of ABC Mining at $50/share = $5,000 total cost
1x covered call sold at $55 strike price = Total Premium received $200
Shares called away at expiration for $55 = $5,500 + $200 = $700 profit in one month
In this example it shows that Joe’s gain is capped at $7 per share. Even if the shares went to $85, Joe’s gain is simply the $5/share increase plus the $2 in premium that he was paid for the covered call. The strike price of the call has limited the upside and that is the trade-off you make when you sell a covered call.
4. Potential Scenarios and Management:
– Stock price remains below the strike price: This is an ideal scenario. You keep the premium from selling the call option, and your stock remains in your possession.
– Stock price exceeds the strike price at expiration: Here, you will likely sell your shares at the strike price, plus you keep the premium earned from selling the call option. While you miss out on potential future gains, you still benefit from the capital appreciation and the premium.
– Stock price drops significantly: This scenario may result in a paper loss for your stock holdings, but the premium from the call option alleviates the impact slightly.
Conclusion:
The covered call strategy provides a clever way to effectively navigate the stock market’s ups and downs. By generating income, reducing risks, and enhancing portfolio performance, this strategy allows investors to optimize their investment potential. While it requires careful decision-making and management, the covered call strategy can be valuable to your investment toolbox. Happy investing!