How to use call options in your own portfolio: covered calls

By Susan April 25, 2012 09:40

How to use call options in your own portfolio: covered calls



In the last post I explained the mechanism of call options. Call options are the right, but not the obligation, to buy a stock at a locked-in price, at a certain agreed-upon date. The seller sells this right, and then sells the stock, if the buyer still wants to buy it at the strike date. The buyer buys this right, and then they buy the stock if they are still interested in it at the strike date.

There are two kinds of call options: “covered” and “naked”.


What does “covered call” mean?


If a person sells the right to another person to buy a stock from them and they have the stock sitting in their portfolio, they have “covered” their position: if the buyer of the option comes looking for the stock, they have it ready to hand over straight away!


Naked calls: don’t go there!


What, on the other hand, you should never, ever do, is sell a call option, without having the stock in your portfolio first.

Essentially, selling a naked call is the scenario whereby, you sold a potential buyer the right to buy a stock from you at a given price, but you don’t own the stock. Still, if the buyer with whom you entered the agreement wants to buy the stock, you will have to honour the contract – meaning, you will have to buy the stock first in order to be able to pass it on to your buyer.

Yes, you could make money if the stock goes down, but you might lose real money (and not just lose out on a bigger profit) if the stock has gone up in the meantime, since you will have to buy it at market price, only to sell it at a fixed price that will very likely be lower than market price.

You can hope to mitigate your loss with the premium, but you will still be selling the stock at a loss.

This is an extremely risky strategy and I would NEVER, EVER recommend it to ANYONE!


So how can you make money from your existing

portfolio with covered calls?


As you can imagine, I only recommend using covered calls – that is, to sell call options on stocks that you actually own!

You can look at each and every one of your existing stocks and see if there are call options available to sell. Identify a price that you would like to sell your existing holding at, as well as a suitable time-frame. Find the corresponding premium and see how much the sale could yield, simply by selling your stocks at the price you want when you want to!

This is why I love covered calls and use them all the time.


Now what do you need to know before you use

covered calls in your own stock market strategy?


For one, the price of the premium decreases as the profit on the stock price increases.

Say you own a stock that is currently trading at €10 and you would like to sell it for €15. The only thing is, considering the underlying stock and a host of other factors, €15 is very high and it’s unlikely that the stock will reach this price in a short time frame.

As the probability of the stock reaching that price (and going above it) is low, the premium that a buyer will agree to pay you to lock in that price will be low as well, to reflect the low probability of the stock price increase.

Indeed, to a buyer it’s more interesting to pay, say, a 2 or €3 premium to lock in a price of €12 if they think the price of the stock could very probably go up to €20. That way, when the stock is actually trading on the market at €20, they will be able to buy it for €12 + a premium of €2 or €3, so €14 or €15 in total.

If you are the buyer and you think the stock won’t go above €16, while the seller wants to lock in a price of €15, you wouldn’t want to pay too much of a premium, otherwise you would be losing money by buying the stock at a price that is very close to the actual market price. Even if the market price is slightly higher than the strike price you agreed to pay, your potential gain might be cancelled out by the premium you paid to lock in the strike price.

Again, a call option is the right to buy a stock, but not an obligation. So if the stock is trading below or at the locked-in price, you don’t have to buy it from the person who sold you the call. But you still spent money on that premium.

So if you think there is a bigger chance of the stock barely reaching (or hardly going above) the locked in price, you wouldn’t want to spend too much on that premium.


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By Susan April 25, 2012 09:40