Many people are familiar with investing in stocks, but less are familiar with the stock derivative called the “covered call”. Covered calls are not overly complicated, and not significantly more risky than owning stocks in the first place (unlike other types of stock options, which can be quite risky). They’re a great way to earn a bit more money from your investments.
What are Covered Calls?
So what exactly is a covered call? Well, it’s a type of stock option. The way they work is that when you own a stock, you can sell them the option of buying that stock from you at a certain time, for a certain price. (The covered part comes from the fact that you already own the stock; if you didn’t, it would be a naked call, and it would be much riskier).
Here’s a quick example to make it clearer. Let’s say you own 500 shares of XYZ stock, and it’s currently $10.00 per share. There may be call options associated with that stock that are worth $0.25 for the stock at $10.50 and expire at the end of the month. If you sold covered calls for all the shares you own, you would make 500 x $0.25 = $125. Now, the thing is, if the stock hit $10.50 or higher, your shares of XYZ are automatically sold at the price $10.50 at the end of the month when the option expires. If it doesn’t hit $10.50, you get to keep your stock. Either way, you get to keep the $125 you made from selling the option.
There are some drawbacks to covered calls. Firs of all, if the price of the stock goes higher than the strike price of the option, you lose out on profit you might have otherwise had. Going back to our example, if the price of the stock had gone up to $11, you would still have had to sell it for $10.50 when the option expired.
Another drawback is that you can’t sell your stock as long as you have an open covered call position. If you want to sell the underlying stock, you need to buy back the calls you sold.
Why Covered Calls are Awesome
There are a lot of really nice reasons to use covered calls. First of all, they’re no riskier than holding the stock in the first place. Secondly, they can provide decent returns. You can often sell options for the upcoming month for as much as 2% the value of the underlying stock (though it varies and may be less than that). 2% return in a single month is pretty good. Over the course of a year, that would be a 24% return, and that’s not counting increases in the value of the stock itself, or any dividend payments you may have recieved from the stock.
You’re probably not going to get rich selling covered calls, but they can provide a nice stream of extra income without much work — just taking them time to sell them once a month, which should take about 5 minutes.