Writing Covered Call Options

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Covered call writing is considered by most experts to be one of the most conservative options strategies for investors and because of this, it is one of the only ones that are allowed by many companies to be traded inside of an IRA account.
It works best with stocks with medium volatility.
Instead of investors buying an underlying stock holding it indefinitely with hopes that it will increase in value only to find that after time has passed it often has decreased or at its best at approximately the same value as when it was purchased, the covered calls allows him to buy an underlying stock and sell options against it which gives him the up front credit into the account for accepting the obligation to sell the stock at a set strike price.
The investor can profit from a covered call if the underlying stock remain stagnant or if it increases in value.
The premium paid to the investor is his to keep if the stock stays at a certain price level or if it increases in value it can be sold on the open market for the increased value.
Sometimes there can be a downside risk from holding the underlying stock shares.
If the value of the underlying shares falls significantly, the loss from holding the stock might far outweigh the gain from the option premium received.
Many options brokers offer buy-writing the trade which is when you buy the underlying stock and sell the call option simultaneously, in a single transaction.
It is a convenience as well as minimizing the risk by not legging into the strategy.
Because options are bought and sold in contracts of a quantity of 100 shares per contract, the minimum purchase is one contract per trade which equals to 100 shares of the underlying stock.
The number of shares in the option contracts must equal the number of shares of the underlying stock.
Example: one option contract equals 100 shares of the underlying stock, i.
e one call option contract per every 100 shares of the underlying stock.
An example of a covered call: XYZ stock has been trading between $20 and $25 per share for the past several months.
You currently own or will purchase 1000 shares of XYZ stock at current market price of $23 per share, (1000X $23 = $23000).
You sell 10 call option contracts (10 contracts = 1000 shares) at a strike price of $20 at the bid price (selling price), of $3 per share collecting $3000 in premium ($3x1000=$3000) in hopes that the underlying stock will remain below the $20 strike price.
This call option contract obligates you to sell to the buyer of the contract, your 1000 shares of stock at the $20 strike price even if the stock price rises to $27 per share losing $7 per share of the trade.
If XYZ stock does remain below the $20 strike price, you keep the $3000 premium you received and also keep the 1000 shares of stock.
The buyer of the option that you sold the option contract to and collected the $3000 premium from, is not interested in exercising his right to buy your 1000 shares at the contract price of $20 per share strike price when he can buy it on the open market for less, therefore the option expires worthless.
Most investors tend to sell the call option in the near month for the earlier expiration, giving the stock less chance to increase through the strike price and also time decay plays an important role in the option value.
Therefore, this process can be repeated monthly to increase the value in an investor's portfolio.
If the stock increases in value to $27 per share which is above the strike price you have two choices: 1) Rather than having the underlying stock called away (exercised), you could keep the the 1000 shares of underlying stock by closing the option trade.
You would buy back the 10 call options contracts you sold for $3 per share and collected $3000.
You would have to buy it back at the at the current option ask price (buying price), which could result in a loss depending on the current asking price at that moment.
Because the value of the underlying stock has increased, we assume that the price to buy back the call option has increased as well.
Maybe to buy back the 10 contracts or the 1000 shares of the $3 per share call options we sold, the option could now have increased to $4 per share to buy it back.
So, to buy it back would be a $1 per share loss on the option trade ($3000-4000=$1000).
But remember the price of the underlying stock has increased from the $23 market value to now $27market value, a $4 gain ($4x1000=$4000) on the underlying stock.
Therefore, closing the trade and buying back the call option that was originally sold produced a gain on trade.
The $4000 gain on the underlying stock minus the $1000 loss on the option trade equals a gain of $3000 on the overall trade.
or 2) You could wait to be assigned (forced to produce your 1000 shares of stock ) at $20 per share strike price, the price you are obligated to sell at, but you keep the $3000 premium your received at the out set of the trade.
The main benefit of a covered call strategy is that you get to keep the option premium when you sell ( write a covered call).
If the shares of stock stays stagnant and never exceed the call strike price you gain the premium you collected in exchange for taking on the obligation to sell the underlying stock at a strike price.
Having an exit strategy is important when trading any options.
The covered call is no different.
Knowing when to close a trade if it should move against you will reduce the risk in the trade.
You are not obligated to stay in a position until expiration day.
If the underling stock should decrease in value you can always buy the call you sold and remove the obligation of delivering the stock and you may be able to buy it at a lower price than you sold it for making a profit on the position.
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