 Selling Covered Calls Option Strategy
When you are fairly neutral on the market and you want
to generate additional income from your investments,
there is an option strategy that is worth your
consideration. This strategy involves selling covered calls
on assets that you own and are willing to sell at a
particular price.
With this strategy, you are selling someone the right to
buy an asset that you own at a fixed price (the strike
price), on or before the expiration date of the option.
This strategy has some nice benefits.
You receive a premium for selling someone the right to
purchase your asset at a particular price that you are
willing to sell it for anyway. If the asset price is below
the strike price at expiration, then the calls that you
sold are not exercised and the premium that you
collected provides additional income for you, increasing
your rate-of-return or reducing your basis in the asset. If
you are writing out-of-the-money calls, the asset may
continually increase in value, yet the options may never
get exercised, allowing you to do this over and over
again. This generates continuous income for you,
increasing your portfolio and generating cash flow for
other investments.
The downside risk of owning the asset is ameliorated by
the option premiums that you collect by selling covered
calls, because the premiums reduce your basis in the
asset.
If the calls that you sold do get exercised, then you are
obligated to sell the asset at the exercise price. But you
essentially sell the asset at a premium from the asset
price that existed when you sold the covered calls,
because you collected the option premium. You have
already agreed that you would like to sell the asset at the
exercise price and the price is augmented by the option
premium that you collected.
Since you are the seller of the option, the time decay of
the option works in your favor. The time-value portion of
the call premium constantly declines with time, going to
zero on the expiration date. The rate of decay is
predictable and is easily calculated by options
analysis programs such as Option-Aid. As the
expiration date approaches, the rate of decay increases.
For this reason, it is often better to sell calls with one
month or less until expiration. After they expire, you can
sell calls on the next month out and collect another
premium.
It is also important to cover risks and caveats of this
strategy.
If the price of the underlying asset goes below the strike
price by more than the option premium that you
collected, then you are losing money on paper. But this
risk is similar to outright asset ownership and is
ameliorated by the option premium that you collected.
When you sell a covered call on an asset that you own,
you are limiting your upside potential. If the asset price
rockets skyward and stays above the strike price at
expiration, then the option will probably be exercised and
you will be obligated to sell the asset at the agreed-on
strike price. So there is some lost opportunity cost
here if the asset turns into a high-flyer.
It is important to analyze your expectations for the
underlying asset before writing the covered call. If you
have a target price in mind for the asset, you can write an
out-ot-the-money covered call approximately at your
target price and collect a lower premium but participate in
the rise of the asset. If you expect the asset price to
remain stable, you can write the call approximately at-the-
money and collect a larger premium without much risk. If
you expect the asset to decline, but you do not want to
sell the asset at that time, the premium you collect from
selling a covered call can help offset the price decline.
If you sell an in-the-money call, the premium you
collect will be even larger, but you run a greater risk of
the option being exercised.
If you are thinking about selling an asset anyway, selling
a covered call on the asset can be used to sell the asset
at a premium, or generate income for you as you stand
ready to sell the asset at a premium. However, if you
have decided that there is considerable downside risk in
an asset and want to eliminate it from your portfolio, then
it is probably better to sell it outright.
When you are analyzing potential option positions, it
helps to have a computer program like Option-Aid that
swiftly calculates volatility impacts, probabilities,
statistics, and other parameters of interest. These
programs can pay for themselves with the first trade that
they help you with.
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