By Justin Shure, CFP
What are covered calls?
A call option is a type of options contract that allows a buyer to purchase a stock at a stated price at a future date and allows a seller to sell a stock at a stated price at a future date. This series will focus on selling calls for income.
To implement a covered call strategy, you will need to own at least 100 shares of a stock that has listed call options. Most large cap stocks have monthly, and even weekly, options traded.
It is important to first understand that selling covered calls has a lot less risk involved than buying calls. If you are covered, you already own shares of the stock. As an owner of the shares, you should be comfortable with the risks associated with that underlying stock. If you were to sell a call against that stock, you would essentially be entering into a contract to sell your stock at a certain price. That price can be lower, at, or higher than the stock’s current trading price. It is essentially a contract to sell your stock at a certain price, at some specific date in the future. When you sell a call option, the premium is immediately deposited into your brokerage account. In return for the premium received, you might have to part with your stock at the agreed upon price at any time up until the options expiration date.
There are 3 main components that are used to calculate the price of an option.
· How close the option’s strike price is to the current price of the stock.
· If the option is at or below the stock’s current price you will receive more premium.
· For options higher than the current trading price, you will receive less.
· The shorter the amount of time until the option expires the less premium received, and the longer in time the higher the premium.
· If the stock has large price swings, this could increase the premium received.
· If there is an event planned around a product launch, or news release the premiums will be greater.
· Periods around an earnings release can also increase the volatility premium.
Although there are more details about options pricing, these are the main factors used to calculate the premium.
Since options contracts are created in 100 share increments, you would need to own at least 100 shares of a stock to sell a covered call against it.
Covered calls can be a useful tool to generate income, reduce risk, and create an exit strategy for a stock.
We will discuss how covered calls can be used to generate income and reduce risk in a portfolio in part 2 of this series.
About the author: Justin Shure, CFP®
Justin Shure, MSF, CFP® is the founder and wealth advisor at Endeavor Strategic Wealth, LLC in Aventura, FL. He has an extensive background in comprehensive wealth management with particular depth in portfolio management. As a fiduciary, Justin provides unbiased, fee-only advice to individuals, families, and business owners. Investment advisory services offered through Bay Colony Advisors.Got Questions About Your Taxes, Personal Finances and Investments? Get Answers!
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