Covered calls, a strategy often employed by investors, involve holding a stock position while selling (or “writing”) call options on that stock. It’s a popular way to generate additional income from a stock portfolio. But what are the real benefits? Let’s dive in.
1. Additional Income Stream
Example: Let’s assume you own 100 shares of Company XYZ, currently trading at $50. You decide to sell a call option with a strike price of $55, expiring in a month, for a premium of $2.
By selling the option, you immediately receive $200 (100 shares x $2). This income is yours to keep, regardless of where the stock price moves.
2. Downside Protection
Covered calls provide a cushion against minor stock price declines. The premium received can offset a drop in the stock price.
Example: If Company XYZ’s price drops to $48, you’d be at a paper loss of $2 per share or $200 for your 100 shares. However, because you earned a $2 premium from selling the call option, it offsets your loss.
3. Potential for Profit in Flat Markets
If the stock doesn’t move much, the option will likely expire worthless, allowing you to keep both the premium and the stock, which you can then use in another covered call trade.
Example: If Company XYZ remains at $50 or slightly moves up to $54 by expiration, the option won’t be exercised, and you retain your shares.
4. Defined Exit Strategy
If the stock price rises above the strike price, it might get called away. But you’ll know in advance the maximum profit you can achieve.
Example: If Company XYZ jumps to $58, your shares get sold at the $55 strike price. Your profit? The $5 increase in stock price plus the $2 premium.
Limitations and Risks
While covered calls have numerous benefits, there are limitations. The main risk is if the stock surges above the strike price, you might miss out on some potential profits since you’re obligated to sell at the strike price. Additionally, if the stock takes a significant dive, the premium received won’t shield you from a major loss.
A covered call program can be an excellent tool for generating additional income and providing a level of protection against price declines. However, like all investment strategies, it’s essential to understand the potential risks and rewards.
Note: Always consult with a financial advisor or do thorough research before implementing any trading strategy. FFR Trading offers several vetted covered call programs. Call today to see if one of these programs might be a good fit for you and your overall financial portfolio.