New to options trading? Here is a strategy to consider
In the hunt for yield, some investors are using covered calls as a way to boost income in their portfolios.
As you build your knowledge and experience with investing, you may be interested in options trading. Options are a type of derivative — a financial contract that derives its value from an underlying asset. Options trading covers a broad spectrum of strategies, all of which are inherently speculative, so it's important to spend the time to make sure you understand the risks before you get involved.
Covered calls, which are considered a conservative options-trading strategy, are a common entry point into the world of options trading. Covered calls allow you to collect cash up front on a stock you already own, when you think the price of that stock is unlikely to significantly increase in the future. The strategy involves "writing" an option contract and selling it to another investor for a price, which is called a premium. The contract gives the buyer the right to buy that stock by a certain date, at a particular price, known as the strike price.
A covered call is usually written in multiples of 100 shares (1 call contract equals the right to buy 100 shares) and is generally only available on more senior-listed stocks, and not on penny stocks.
The advantage for the covered call seller is that they receive the premium paid by the buyer. Each call option has its own premium, which depends on the current stock price, how volatile it is and the expiry date of the contract (the longer away it is the higher the premium, in most cases).
The disadvantage to the covered call writer is that, if the stock reaches or surpasses the strike price, the buyer will likely exercise the right to buy the security at the strike price. In that case, the writer misses out on the additional gain, which could be larger than the proceeds from writing the call option. That means the writer's potential gain is capped at the strike price, whereas the buyer's potential gain is unlimited. In reality, many call options aren't exercised, which means investors can collect cash for writing the call, without having to sell the stock.
Used effectively, covered calls can help investors earn income to enhance their returns, and reduce volatility in their portfolio, by offsetting losses in a down market.
Take for example an investor who buys a stock for $100 and writes a call at a strike price of $120. (For simplicity, in this example, assume the contract represents the right to buy one share, instead of 100 as would be the case in real life.) If the stock price goes up past the strike price and the call is exercised, they receive a $20 capital gain plus a premium of, let's say $5.
If the stock stays below the strike price and goes unexercised and the option expires, they pocket the $5 premium and still own the stock. If the stock falls to $90, they're down $10 but still receive the $5 premium, which mitigates the loss. But beware: the price of any stock has the potential to drop quickly — even all the way to $0. If the stock looks like it's going to drop, and the writer wants to sell it, and they are not approved for uncovered ("naked") calls, they would have to buy back the option contract first.
Keep in mind that in real circumstances, there are commissions to be paid on the trades, which need to be considered. There is also a chance an option can be exercised early. While the writer receives their capital gain and premium sooner, they might miss out on a dividend paid before the original expiry date.
Covered calls are not for beginning investors — their use requires an appropriate level of knowledge and experience. For that reason your brokerage must approve your request to use this options strategy. Most requests to write covered calls are approved for use in registered accounts or in margin accounts (although a covered call strategy does not involve any margin). Investors who apply to use more complicated options strategies, such as uncovered writing and spreads, need to demonstrate an even higher level of investing sophistication.
For investors who want to buy into the strategy, but leave the work to others, there are a handful of exchange-trade funds (ETFs) that include covered call writing in their mandate — such as the PowerShares S&P 500 BuyWrite Portfolio ETF or the Horizons S&P 500 Covered Call ETF. Investors should be aware these ETFs can often have a higher turnover rate than more traditional index funds and may come with higher expense ratios.
There are many online resources to help covered call writers, including pricing, research and trading tools. The Montréal Exchange, which is dedicated to trading derivatives, has good educational resources on derivatives trading, including on covered calls.
This content is for educational purposes only and is not a recommendation to buy or sell. Transactions in Options carry a higher degree of risk. Purchasers and sellers of Options should familiarize themselves with the type of Option (i.e. put or call) which they contemplate trading and the associated risks.