If you think options are risky, you’re right.
But you’re also wrong.
The truth is, options cover a wide range of strategies—from leveraged bets on a stock’s direction… to bets on the passage of time… to income strategies. And each comes with varying degrees of risk.
In these pages, I’ve talked about buying protective put options on stocks you own as a way to create your own market insurance. And I’ve explained the potential risks and rewards of buying puts outright.
Today, I’ll walk you through the lowest-risk option strategy: selling covered calls.
If you’ve never tried this strategy, here’s why it should be in every income investor’s arsenal… and when to use it.
Selling covered calls is as low a risk option trade as they come. Under the cover of a long position, investors can use calls to generate some extra income.
A covered call strategy involves selling calls on a stock you already own. In other words, it creates another stream of income on the stocks you already own.
In a nutshell, the strategy involves two elements: first, owning a stock… and then selling a call option on that stock.
As with any investing strategy, to benefit from call writing, you have to know when best to use it.
You see, every option has two sides. When you buy a call option, it gives you the right—but not the obligation—to purchase 100 shares of a stock at a predetermined price (called the “strike” price) at any time prior to the call option’s expiration date.
When you sell a call, you take the opposite side of this transaction. By collecting a premium, you accept an obligation to sell the stock to the call owner should this stock rise to or above the option’s strike price.
There are four conditions that are best for this type of trade:
No. 1: If you’re neutral or even slightly bearish on a portfolio holding, it could be a great candidate for covered call writing—if you don’t expect any future appreciation on a stock, you could choose to be “paid” by selling a call on it.
As a call writer, you’d have an obligation to sell the stock at the strike price (if the stock rises to or above that price). Therefore, you would not benefit from any further upside—if the stock in question moves higher, you’d be forgoing this price appreciation.
But if the stock stays flat as you’ve anticipated, the call would expire worthless and “out of the money.” In this case, you’d get to keep the premium, and—if your opinion on the stock hasn’t changed—you could keep doing the trade over and over again.
No. 2: For the same reason, if you’re only moderately bullish on a portfolio holding, it could also be a good candidate for a covered call trade. When you don’t anticipate much upside, that stock might be a good tool for generating some extra income.
No. 3: If you’re more worried about downside protection than you are excited about upside potential, covered calls can help.
If you sell covered calls on a stock and the price of that stock declines, the total value of your shares will decrease. But the premium you’ve collected would counter some (or all) of the loss.
Still, a covered call isn’t an ideal answer. While, thanks to the premium collected, you’ll have some downside protection, it comes at the price of strictly limiting your upside profit potential on a position.
No. 4: If you want (or need) to generate some extra income on your account, income investors often employ the covered call method as a supplement to more traditional dividends.
By selling a covered call, you create an obligation to sell your shares at a predetermined price under certain conditions. But in exchange, you get paid. For many investors, it’s a good deal.
Better yet, with covered calls, you can even generate income on stocks that normally don’t pay dividends, such as Twitter (TWTR), Uber (UBER), Snap (SNAP), or some other zero-yielding stock you just happen to own.
Let’s say, for example, that you don’t expect much upside from Acme Co.—a speculative stock you bought on advice from your neighbor. You’re not aggressive enough to trade puts on the stock, and you’re not quite ready to sell it, but you’d be happy to create some downside protection and generate a bit of income on this zero-yielding stock.
In that case, you could sell a covered call with a strike price a few percentage points above the current price of Acme. You’d sell one call option (one contract) for every 100 shares of Acme you own. (The number of contracts you sell doesn’t matter; they just need to be covered by the shares you own.)
Once you sell covered calls on Acme, one of three things could happen: Acme could stay flat, it could rise in price, or it could fall.
Let’s say you generated $50 from each contract sold. If Acme declines in price, the premium will help counter some of the loss. And you can continue to sell calls on Acme once your calls have expired. You just need the stock to remain under the strike price.
If Acme rallies and gets taken away from you, good riddance. You’d effectively be selling it at the strike price, which, if you remember, was set a few percentage points higher than the price you started with at the beginning of this process.
In a future issue, I’ll focus on how to make the most of this low-risk strategy…
Broker guidelines for trading options
Trading options isn’t as simple as buying a stock outright. You have to apply through your broker for approval.
There are generally four levels of options trading—and the higher the level, the higher the risk. For most brokers, Level One allows writing covered calls. Level Two allows buying puts and calls and trading secured puts. Levels Three and Four are required for executing various other strategies, such as trading “naked” calls and puts.
The application will look something like this.
A covered call trade is typically rated “Level One” by your broker—the lowest risk level—because your obligation is covered by the shares you already own.
In future letters, we’ll talk more about the world of options and the risk/return profiles of these categories.
