The 6-Week Options Trading Kickstarter: Covered Calls
Steve Smith breaks down a popular options strategy.
Editor's note: To help investors get their feet wet with options trading, Minyanville has launched this "6-Week Options Kickstarter," an educational series aimed at increasing understanding of the basic nuts and bolts of options. In this series, veteran options trader Steve Smith will take you through options fundamentals with an emphasis on real-world applications. Note: Intermediate or advanced-level traders may get more mileage out of Minyanville's 9 Weeks to Better Options Trading series.
Covered calls are among the most popular options strategies pushed by sell-side brokers and employed by traders.
But the reasoning behind both sides' attraction also exposes some myths that retail investors should be aware of before embracing this approach. Let's take a look at the pros and cons.
A covered call is created by being long a stock, and short call options on that same stock.
Typically, one call is sold for every 100 shares of stock.
If the positions are created simultaneously it is often referred to as a "buy/write."
The premium received from the sale of the calls reduces the effective cost basis of the stock, providing some downside protection, and a potential boost – or reduction -- in returns depending upon the price action.
Let's look at an example.
On Monday, with IBM (NYSE:IBM) trading at $200 per share, one could sell the September $205 calls for $1.80 per contract.
As with all options positions, there is a tradeoff between the benefits and costs. While the downside is cushioned a bit, the potential upside is capped as the stock will be "called away" if it is above $205 at expiration. In other words, if the stock is above $205 at expiration, the buyer of the call option will exercise his or her right to take ownership of the stock at a cost of $205 per share.
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