Portfolio Protection with Covered Calls

Options investing strategies are usually not for beginners. If you are a buy and hold investor though, it is important that you know the basics of options. There are levels of options trading and usually your broker has to approve you to be able to trade those strategies. Each level requires more education on options and more capital. The first level is the one that I will talk about today and that is covered calls.

Options 101

If you’ve never heard the word stock option before, here is a quick run down on options. A stock is usually traded one to one. You buy one share at a time and own only one share. A stock option is based on the underlying stock and trades in one unit per 100 shares. So one stock option typically controls 100 shares. Instead of buying and selling options you would long or short an option contract. It’s important to get this terminology straight because options can get confusing the first time you learn about them. There are two types of option contracts, calls and puts. When you long a call, you have the option to buy 100 shares of the underlying stock at a set price, usually called the strike price. When you long a put, you have the option to sell 100 shares of the underlying stock at the strike price. If you short a call, you have the obligation to sell and if you short a put, you have the obligation to buy. Confused yet? Well let’s just stick with covered calls for now.

What are Covered Calls?

A covered call is an option contract. Let’s say you own 100 shares of your favorite cell phone manufacturer. If you sell one call you will receive cash up front based on the value of the option and you will be required to sell at the agreed upon price, the strike price. The value of the option is determined by the market and is based on intrinsic value and time value. An option contract does not execute until it reaches a certain point, the strike price. For a covered call, the price of the underlying stock has to rise or pass the strike price before you, as the option seller, will be obligated to part with your 100 shares.

How Can I Use Covered Calls?

So how can this help you as a buy and hold investor? The covered call strategy is often used by buy and hold investors that are familiar with the volatility of their stock. Let’s go back to the cell phone manufacturer that you own. You have owned this stock for so long and you know that it is a low volatility stock. You think in the next few weeks the price will only rise by about 5 bucks. So you sell a call, which is covered by the stock you own. You choose the current price of 50 plus 7 bucks just to be safe which puts you at a 57 dollar strike price. Options expire at a certain date. For this option, it expires in 2 weeks. In those two weeks the stock price only goes up by 4 dollars. You earned an upfront price for selling the covered call that you get to keep, plus now you have price appreciation. Could you do this every month? Of course. Will your stock get called away at some point? Possibly. There are various factors that effect option pricing that you should learn before jumping in. Check out the Chicago Board of Options Exchange for great webinars and tutorials.

Have you tried using options for your portfolio?

Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options (ODD). Copies of the ODD are available from your broker, by calling 1-888-OPTIONS, or from The Options Clearing Corporation, One North Wacker Drive, Suite 500, Chicago, Illinois 60606.

This post was written by Latisha.


Comments

Portfolio Protection with Covered Calls — 9 Comments

  1. Nice primer on covered calls, I would also like to add that covered call ETFs have also appeared recently. BMO has Banks and Utilities covered call ETFs which appeals to income investors because of the high yield.

  2. Great clear explainations of option terms! In your example, are you saying you are making money on both sides? I can see why this is so tempting, but if things go against you, you could easily lose on both sides as well. Can I say options help investors trade a stock’s volatility?

  3. If you are using cc writing to protect your portfolio on stocks that you want to retain, consider writing out-of-the-money calls (higher than share price)at least 5% higher. If the stock price is higher than the strike price (agreed upon sales price)by expiration Friday you may need to “roll” the option (buy it back and sell the next month’s option). Also, if the stock generates a dividend, there are times the shares may be sold earlier than the expiration date. I have written many articles on these topics and should be carefully mastered before plunging in. I agree with Latisha that this is a strategy that should be considered for portfolio enhancement.

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