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Covered Calls Made Easy: The Basic Concepts and Why to Sell Covered Calls

Covered Calls offer investors a relatively low-risk way to add significant income to a portfolio without taking on additional risk. Taking advantage of this investing option requires the investor to understand the process, and invest time weekly to monitor your positions and adjust quickly to events in the marketplace. This three part series will go through: 

  1. The Basic Concepts and Why to Sell Covered Calls
  2. Picking the Right Stocks for Covered Calls
  3. The Mechanics of the Covered Call Strategy

What are Covered Calls? It is a strategy where you are selling call options on stocks that you already own. You get to pocket the call price immediately. In return, however, you are giving the buyer of the call option the right to purchase your stock from you at the strike price before the call expires. By selling these call options, you potentially will have your stock “called away” from you, and when that happens, you might lose some upside that the stock travels above the agreed to strike price.

Why would you embark on this strategy? If you are looking for income out of your portfolio, this is a way to multiply the income in a relatively riskless process.

Covered Calls offer three different ways to earn returns on your investment:

Price Appreciation Stock prices generally move up - you will get full advantage of that (up to the level of the Call Strike Price.) It is important to select stocks that you want to own, and that you believe have good price appreciation potential.
Dividends You are in this for income, so you should start with stocks that have a reasonable dividend that looks secure and has growth potential.
Money from Selling Calls Each time that you sell a call, you pocket a fee. That fee is there to reward you for selling your stock if it goes above the strike price.

Once you have sold the option, only two things can happen.

1.The most likely is that the call option that you have sold will expire worthless. That is right – you just sold something, got value, and the buyer ends up holding a worthless option.

Or

2. The stock does appreciate in value above the strike price. In most cases the owner of the option will execute the option, and then the buyer will purchase your shares at the strike price.

While option 2 seems like you have lost, you have actually gotten good price appreciation, the option call price, and any dividends along the way. It is not a bad way to lose! You are winning by losing.

Let us run through an illustrative example:

Assume that you own Applied Materials (AMAT). How would a covered call work? Well look at the picture below:

covered calls

Currently, the stock AMAT is trading around $44 on April 18th. I have the ability to sell a covered call at a $46 strike price with an expiration of May 10th. IMPORTANT: each options contract controls 100 shares. The price that I will receive for selling this call option is $60. On the surface that may not sound like much, but  remember, this option expires in just three weeks. So if AMAT does not get above $46 in the next three weeks then I will pocket the $60 and the buyer of the call option will get nothing. Then I can go sell the next call option for another 3 weeks out, and keep pocketing my premiums.

On the other hand, if it does go above $46, then the buyer of the option will call away my stock, and I will have made $4600 (remember that each option is 100 shares) + $60… so $4660 from the $4400 it is trading today.  That is a 6% return in a little over three weeks.

In summary, the Covered Call Strategy is a great way to multiply your income, and earn higher returns. There are some nuances involved with maximizing the strategy which we will cover in the next two posts, and you can watch this video to see how Chaikin Analytics is the perfect tool to execute the strategy.

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