Boost Your Portfolio: Income & Diversification with Covered Calls
Covered calls are an options trading strategy designed to generate income while helping you diversify your holdings. Let’s unlock the secrets behind covered calls, guide you through the process and provide examples to help you understand this popular investment strategy.
WHAT IS A COVERED CALL?
A covered call is a stock options trading strategy where an investor, who owns shares of a stock, sells call options on that stock to generate income.
A call option gives the buyer the right, but not the obligation, to purchase the underlying stock at a predetermined price, called the option's strike price, before the option's expiration date.
Selling covered calls allows you to generate additional income, while owning the underlying stock is considered "covered" because you can deliver the shares if the option is exercised.
EXAMPLE TRANSACTION: COVERED CALL OPTION
Suppose you own 100 shares of XYZ Tech, a fictional technology company. The current market price of XYZ Tech is $50 per share.
You believe that the stock price will moderately increase over the next month but would like to generate some income in the meantime by selling a covered call
Step 1: Research the options chain. You start by looking up the options chain for XYZ Tech. You find that there are multiple call options with different strike prices and expiration dates available for trading.
Step 2: Select the strike price and expiration date. After analyzing stock prices and the options chain, you decide to sell a call option with a strike price of $55 and an expiration date one month from today. This strike price is higher than the current market price, giving you some room for capital appreciation. The premium for this call option is $2 per share.
Step 3: Write the covered call. You sell one call option contract (each contract represents 100 shares) and receive a premium of $200 (100 shares x $2 per share). This premium is your income from the transaction.
There are three possible outcomes at the expiration date:
Outcome 1: XYZ Tech's stock price remains at $50 or above, but below $55. If the stock price stays below $55 at the expiration date, the call option expires worthless. You keep the $200 premium and still own the 100 shares of XYZ Tech. You can choose to write another covered call if you wish.
Outcome 2: XYZ Tech's stock price is above $55. If the stock rises above $55, the call option is exercised, and you'll be obligated to sell your 100 shares at $55 each.
You still keep the $200 premium, and your total return from this transaction will be the $500 capital gain ([$55 - $50] x 100 shares) plus the $200 call option premium, totaling $700. (Keep in mind your taxable capital gain depends on your cost basis)
Outcome 3: XYZ Tech's stock price falls below $50. If the stock price drops, you'll experience a loss in the value of your shares. However, the $200 premium received from selling the call option will help offset some of the loss. You can continue to hold the shares or consider other investment strategies.
This example of a covered call demonstrates a simple covered call transaction, illustrating how the strategy can generate income and provide some level of downside protection.
Remember that each investment situation is unique, and it's essential to carefully consider your financial goals and risk tolerance when implementing any options trading strategy.
HOW CAN COVERED CALLS GENERATE INCOME?
When selling covered calls, you receive a premium from the buyer. This premium is the income you generate from the transaction.
The premium depends on factors such as the strike price, the expiration date, and the stock's volatility. Generally, a higher premium is associated with a higher likelihood of the option being exercised.
HOW CAN COVERED CALLS CONTRIBUTE TO DIVERSIFICATION?
Covered calls can help you slowly diversify your stock holdings by having them called away if the share price increases.
If the stock price rises above the strike price and the option is exercised, you'll be obligated to sell your shares at the strike price. This can help you gradually reduce your exposure to a particular stock, freeing up capital to invest in other opportunities and diversify your portfolio.
DID YOU KNOW?
Covered call writing is often disallowed for employees of companies that have trading windows.
Options strategies such as a covered call strategy may result in your underlying stock being sold at a time outside of your trading window. Therefore, taking advantage of this strategy for your current employer's stock is often not possible.
However, should you terminate employment, this disqualification is no longer of concern because you no longer have any timing restrictions of when you can sell your underlying stock.
WHAT RISKS ARE INVOLVED IN WRITING COVERED CALLS?
One risk is that if the stock price rises significantly above the strike price, you may miss out on potential capital gains since you'll have to sell your shares at the lower strike price.
Another risk is that if the stock price falls, you'll still experience a loss in the value of your shares, although the premium received from the call option will help offset some of the loss.
HOW DO I CHOOSE THE RIGHT STRIKE PRICE AND EXPIRATION DATE FOR MY COVERED CALL?
The strike price and expiration date you choose will depend on your investment goals and risk tolerance. Generally, a higher strike price gives you more room for capital appreciation but may result in a lower premium.
A longer expiration date typically offers a higher premium but increases the risk of the stock price moving significantly. Striking a balance between potential income and capital appreciation is crucial when selecting the right strike price and expiration date.
CAN I WRITE COVERED CALLS ON ANY STOCK I OWN?
No. Not all stocks have options available for trading. To write covered calls, the stock must have listed options. You can check if a stock has options by searching for its options chain on a financial news or brokerage website.
Additionally, you may have employer restrictions on writing covered calls. Publicly traded companies usually put trading restrictions (blackout windows) on most of their employee base to restrict the potential for insider trading. These blackout windows generally apply to all trading activities for the employer stock. Therefore, trading options on the company stock that you work for is generally not possible.
HOW DO TAXES AFFECT COVERED CALL INCOME?
Taxes on covered call income vary based on factors such as your holding period and the option's expiration date.
In the United States, short-term capital gains are generally taxed at a higher rate than long-term capital gains. While you benefit from the covered call premium right away, the taxation of the premium only occurs once the option has expired. It is always best to consult a tax professional to understand the tax implications for your specific situation.
WHAT TOOLS OR RESOURCES CAN HELP ME WITH COVERED CALL INVESTING?
Many online brokerages provide tools and resources to help you analyze and execute covered call trades. Additionally, financial news websites and investment blogs often share insights and strategies for covered call investing.
WHAT IF I AM NEW TO INVESTING?
A common financial myth is that trading stock options is only suitable for advanced or professional investors.
While options trading does require a certain level of knowledge and understanding, strategies like covered calls are accessible to individual investors with a basic understanding of stock options. With the right education and resources, investors can benefit from the income and diversification opportunities that covered calls provide.
FINAL THOUGHTS
Covered calls can be an effective strategy for generating income and diversifying your stock portfolio.
As a tech professional, staying informed and optimizing your investments is essential. Our firm offers a comprehensive covered call service tailored to your unique needs and financial goals.
We invite you to engage with our experienced team of financial planners and utilize our cutting-edge tools to maximize the benefits of covered call investing. Please reach out to us today to explore how we can help you achieve financial success and unlock the full potential of your investment portfolio.
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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.
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.