When you invest, you let your money grow for you. One way to do this is to trade covered call options.
Once you have a savings account, an emergency fund to handle unexpected expenses, and an established retirement account, you can move on to the next step in your journey toward financial freedom – investing!
Writing Covered Call Options – The Basics
“Buy and Hold” is the stock advice given by many financial planners and brokers. This method involves picking a good stock and keeping it in your portfolio for many years to come.
That is good advice, but there is an additional way to make income from the stocks you own. This strategy is called “writing covered call options.”
You might use a broker’s services to purchase stock, or you might enjoy buying stocks yourself using one of the many online brokerages.
Today, many online brokerages offer free commissions, saving you money when buying and selling stocks. And it can be fun to do it yourself.
There is a stock market, such as the New York Stock Exchange, where stocks are bought and sold.
And there is an options market, such as the Chicago Board Options Exchange, where options are bought and sold.
Options are contracts, which give the buyer the right to buy or sell shares of stock.
Roles of the Buyer and Seller
The buyer of a “call option contract” has the right, but not the obligation to buy a specific stock at a set price (this is called the strike price) anytime on or before the option contract’s expiration date.
The seller of a “call option contract” gives someone the right to buy from him or her the shares of stock they own at a set price (strike price).
The contract has an expiration date, after which the contract expires. “Writing” an option contract means “selling.” The strategy of writing covered calls is to make money on stocks you own.
The term “covered” means that you own the shares of stock that you are giving someone the right to buy from you…your contract is “covered.”
Writing a covered call on a stock you own is like renting out the stock. Perhaps you own a second home as an investment property.
While you hold that property for several years, anticipating it going up in value when you sell it, you can make monthly income from it in the meantime by renting it out.
In the same way, you can “rent out” stock you own by writing covered call contracts.
Understanding the Option Contract
One option contract represents 100 shares of stock. Suppose you own 100 shares of a company’s stock. Let’s say the stock is worth $20 a share, so you have $2,000 invested.
You would like to hold the stock for a long term and hope it will go up in value as the years go by.
You can sell one option contract that will give someone the right to buy those 100 shares from you at a set price between today and a month from now.
First, you’d want to be paid something for giving this right, and by doing so you would receive a “premium” payment for selling that option contract.
Consider Also: Understanding Broken Wing Butterfly Options Trading
Understanding the Premium Payment
The amount of that premium will depend on many factors, but let’s say you receive $.50 per share, for a total of $50, since one option represents 100 shares of stock.
Second, you don’t want to sell your stock for what you paid for it, so you agree to sell it for $22 per share.
You write a covered call, for which you agree to sell your 100 shares of stock at $22 per share anytime between now and an expiration date one month from now.
For that, you receive $50 in your trading account immediately.
If someone does take you up on your offer, you will make another $200 from selling the stock (you bought it at $2,000 and sold it for $2,200).
If the company’s stock doesn’t go above $2,200 in the next month, no one will want to take you up on your offer, so you keep your stock and the $50 rent.
You can write a covered call the next month, and once again receive money as you rent out your stock!
Trade Covered Call Options: Pros and Cons
If you are trading stocks online, it is very easy to buy and sell options on your stocks. This all sounds wonderful, so What’s the Catch?
You intend to hold your stock for a long time in hopes of gaining capital appreciation as the company grows and it’s stock becomes more valuable.
However, if the stock you own goes up above the strike price you have selected ($2,200 in our example) before the option contract expires, you will most likely have your stock sold, taken by someone exercising their right to buy your shares at $2,200.
That means you may miss out on a bit of profit. But hey, you made money! In fact, you might have been able to “rent out” your stock numerous times before you had to sell it.
Because there is a risk of having your stock sold and taken away from you, you should not write covered calls on stocks that you aren’t willing to part with.
You can, of course, always buy shares of stock again, although you might not get them at the lower price that you originally did.
Another way to use covered call trades is to deliberately pick stocks that are highly likely to be bought from you.
In return, you are paid for taking that risk, and you’ll make money on the sale of the stock too, since its price will be higher than when you bought it.
Trade Covered Call Options: In Conclusion
The ability to trade covered call options is an excellent way to generate short-term cash.
Options trading can be risky.
Writing covered calls, however, is a conservative strategy that actually makes stock market investing less risky, and it should be part of your “trading box of tools.”
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