Your New Covered Call Investment Strategy

By Marc Abrams on October 3, 2009

In today’s stock market, investors have more choices than the purchase of stocks, bonds or mutual funds. Strategies such as the buying and selling of options can increase returns or minimize losses.

Options are categorized into two different types, a call option and a put option. We are going to discuss call options. A call option is defined as a contract that gives the holder the right to buy the underlying security at a specified price for a certain, fixed period of time.

Generally, buying one option contract gives the purchaser the right to buy 100 shares of a stock. If the stock price exceeds the intended price (known as the strike price) the option can be exercised and profit made on the difference between the current price and the strike price.

As long as a market exists for the option, it can be bought or sold any time until it expires. Options become worthless at expiration if they are not sold or exercised prior to that date.

It is possible for an investor to be either a buyer or a seller for a call option. Selling naked calls means that an investor will sell an option without owning stock to offset the option. This is a high risk strategy and therefore most brokers will require substantial equity in your account before they approve you for this strategy. If you sell a naked call, General Electric, for example at a $15 strike price with two months left until expiration you would receive $100. That $100 represents the option premium. If the stock stays below $15 per share you get to keep the $100 premium which you made with no money invested because you sold a naked call. Sounds fantastic, right? However, if stock shoots up to $40 per share, you would be obligated to go to the market and purchase 100 shares of GE for $4,000 and deliver it to the option holder for a loss of $2,400 ($1,500 strike price received less $4,000 cost of shares plus $100 option premium received.) I hope you can see why this strategy carries unlimited risk. I do not recommend this strategy for new option traders.

A safer strategy is to sell covered calls, where the investor owns the underlying stock, and sells the call option. If you had owned the GE stock in the above example you would have simply delivered the 100 shares you already owned to the option holder, and received the strike price of $1,500, and kept the $100 premium.

I know what youre thinking. I just gave up all that increase in stock price by selling GE at $15 per share instead of $40 per share. This is true. You should never sell covered calls on stock that you want to keep. Before you sell covered calls you need to look at your investment in the stock and calculate your potential gain/loss if the stock were to get called away.

I successfully use covered calls as part of my investment strategy. Covered calls provide a safe, reliable method for me to generate consistent returns regardless of which direction the stock market moves. The key is learning a little known variation of this popular strategy to increase your success rate in all market conditions.

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