Covered Call Writing is a conservative strategy for investing in stocks that is meant to reduce risk and increase income. In short, stock options are contracts in which you buy or sell the right to buy or sell. Even though there are eight different kinds of options contracts, we're only interested in "Covered Call Writing," which has a low risk.
How it works is as follows: Say it's August and you pay $48 per share for 300 shares of XYZ stock. XYZ gives a dividend of 50 cents per share every three months. So, if the price never goes up or down, you'll earn 4.2% per year.
You would also take part in Covered Call Writing at the same time. You would "write three January 50 Calls" to do this. This means that you are selling the right for someone else to buy the stock from you (they "call" it away) between now and the third Friday of January at a set price of $50. (On the third Friday of every month, all contracts end.)
Each contract is worth 100 shares, so three contracts equals 300 shares. The buyers pay you a fee of $3.5 per share, or $1,050, which is called a "premium." (The premium is based on how long until the option expires and the difference between the current price and the "strike price," which is $50 in this case. So, the premium changes all the time.)
If you don't cancel, there are only two things that can happen next: either the contract will be used or it will expire in January without any value. You get to keep the $1,050 either way. Clearly, this plan can pay off in a big way. Among the pros are the following:
- When you buy a stock, you set a price that will make you money when you sell it. If you use the option, you are sure to make money;
- You lower your risk because the premium lowers the price you paid for the stock;
- Your annual return goes up by a lot more than what the dividend alone would have done.
But there are other things to think about. For one thing, you're lowering the amount of money you could make. You won't sell for more than $50, no matter how high the stock goes. You can solve this problem by buying back your option, which will make it useless. You might do this if you think the stock will go up a lot in the future and don't want to miss out on the gains.
Also, you haven't made it less likely that the price of your stock will go down. The only thing you can be sure of is that if XYZ goes down by $25, your option will not be used. You can protect yourself by "buying a January 45 put," which gives you the right to sell your stock for $45 on January 45. This is the opposite of what we've talked about so far, and it's meant to limit losses instead of protect gains.
Because prices can go down, you should choose a high-quality, blue-chip stock that fits your budget and has a stable trading range, solid fundamentals, high dividends, and good growth potential.
Protected Call Writing is not a reason to buy stocks, but if you already do, this strategy might help. Before you open an account, you must get and read "Characteristics and Risk of Standardized Options," which is put out by the Options Clearing Corporation in partnership with the NASD and all of the major U.S. stock exchanges. Any broker or financial advisor can give you a copy of the booklet.
