Covered Calls 101
In the world of options trading, covered calls stand out as a versatile strategy that offers both opportunities for income generation and risk management. Covered calls also provide a unique opportunity for departing employees to continue to benefit from their stock ownership while generating income, even after leaving the company. In this post, we'll delve into what covered calls are, how they work, and explore the pros and cons of implementing this strategy. We’ll also share more about our Covered Call service, in the event that you want some guidance and support implementing this investment strategy.
WHAT ARE COVERED CALLS?
A covered call is an options trading strategy where an investor holds a long position in an asset, typically stocks, and sells call options on that same asset. A call option gives the buyer the right to buy your stock from you at a specified price (“strike price”) in the future. The motivation for the buyer is that they believe the stock will trade at a higher price than the option strike price before the option expires. As the seller, you are rewarded for that risk with a premium (“income”) paid by the buyer. In summary, the investor (you) are able to generate income from the premiums received from selling the call options, while still benefiting from additional upside potential in the stock's price today up to the strike price agreed to.
HOW DO COVERED CALLS WORK?
Ownership of Asset: First, to execute a covered call, you must own an asset such as a share of a company’s stock. This ensures that you can fulfill your obligation if the call options are exercised.
Selling Call Options: Next, you sell call options on the owned assets. Essentially, you agree to let the buyer purchase their shares from you at a certain price ("strike price") before a certain date (“expiration date”).
Premium Collection: In exchange for giving the buyer this option, the buyer gives you some money upfront. This is called a premium. Think of it like getting paid a little something for letting them potentially buy your shares later.
Potential Outcome 1: If the stock price stays the same or goes down, usually, the other person won't want to buy your shares at that higher price. So, you get to keep your shares and the money they paid you.
Potential Outcome 2: If the stock price goes up and is higher than the price you agreed on, the other person will want to buy your shares from you at that lower price. If they do, you sell your shares to them at that price, but you still get to keep the money they paid you upfront.
ADVANTAGES OF COVERED CALLS
Income Generation: One of the primary benefits of covered calls is the ability to generate income through premium collection. This can provide you with a regular stream of cash flow, especially in sideways or slightly bullish markets.
Downside Protection: Since you already own the underlying asset, the premium collected from selling the call options provides a buffer against potential downside risk. This can help mitigate losses in the event of a decline in the stock price.
Customizable Strategy: Covered calls offer flexibility in terms of strike prices and expiration dates, allowing you to tailor the strategy to their risk tolerance and investment objectives.
Potential for Capital Appreciation: While the main goal of covered calls is income generation, you can still profit from any increase in the stock price up to the strike price of the call options.
Diversification Assistance: It may be likely that you have a concentrated stock position that you’re looking to diversify to a lower allocation. Covered calls can be a method to assist you with that process. With this strategy you can collect an income stream while waiting for your shares to be called away at desired higher prices, which in turn helps with your diversification strategy.
DISADVANTAGES OF COVERED CALLS
Limited Upside Potential: One drawback of covered calls is that your potential upside is capped at the strike price of the call options. If the stock price exceeds the strike price significantly, then you miss out on additional gains.
Obligation to Sell: Selling covered calls entails the risk of being obligated to sell the underlying asset at the strike price, even if you would prefer to hold onto it. This can result in missed opportunities if the stock price rises sharply.
Risk of Assignment: There's always the possibility that the call options may be assigned before expiration, especially if the stock price moves substantially in the buyer's favor. This can lead to the early sale of the underlying asset, potentially at a lower-than-desired price.
Market Volatility: High levels of market volatility can impact the effectiveness of covered calls, as sharp price movements may increase the likelihood of the options being exercised or assigned prematurely.
COVERED CALLS WITH DIVERSIFY
Do you have vested stock left over from past employer(s) that is causing you to have a concentrated stock position? If so, you may want to consider Covered Calls.
Our Covered Calls service strives to empower eligible clients to achieve maximum return potential through customized covered call strategies. These strategies are tailored to diversify your concentrated stock positions while generating income, ensuring that your money is working for you. This service is custom-curated to your needs and financial goals. When you enroll in our Covered Call service, you can choose one of three strategies - Conservative, Moderate, or Aggressive. These strategies have different weighted call probabilities, meaning they each represent different speeds of diversification. Understand that our strategies are a starting point and can be customized to your needs with the help of your Advisor. The rest is handled entirely by our Wealth Team as part of this white glove service, taking the stress and hassle off your hands. We will write the covered call contracts for your specified amounts of shares utilizing the strategy or portfolio chosen. As premiums accrue and shares are sold, we reinvest these proceeds and any resulting cash back into your Wealth Management portfolio, ensuring a seamless integration into your overall diversification strategy.
If you’re looking to implement Covered Calls as part of your investment strategy, set up a free consultation call with us.
Covered calls can be a valuable addition to your toolkit, offering a balance between income generation and risk management. By understanding the potential benefits and drawbacks of this strategy, you can make informed decisions that align with your financial goals and risk tolerance.
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Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed.
DiversiFi Capital LLC is a registered investment adviser located in CA and may only transact business or render personalized investment advice in those states and international jurisdictions where we are registered, notice filed, or where we qualify for an exemption or exclusion from registration requirements. Any communications with prospective clients residing in jurisdictions where DiversiFi Capital LLC is not registered or licensed shall be limited so as not to trigger registration or licensing requirements.
Past performance is not indicative of future returns, and investing always carries inherent risks, including the potential loss of principal capital. Any investment strategies are specific to individual clients and may not be representative of the experiences of all clients.