With the stock market today at record highs, investors are understandably nervous about their equity positions. Many analysts believe that a correction may be coming sooner than we would like.
Of course, an option is to simply sell your holdings but many investors fear missing out if the market continues to rise. Instead, wouldn’t it be wonderful if there was a way to take some money off the table while still being able to participate in the upside of the market?
One way to accomplish this may be selling options against the stocks you already own, called a covered call strategy.
To understand how this would work, we first must understand just what an equity call option is. A call option gives the buyer the option to purchase a stock at a given price, called the strike price, in the future in exchange for paying a specified amount of money called the premium.
For example, today Apple is trading at $170 a share. I can purchase a call option to buy Apple at a strike price of $180 six months into the future for a premium of around $10 per share. Clearly this would benefit me if Apple, in six months time, trades above $180 as I purchased the right to buy it at $180 even if the market price of Apple is at $300 per share at that time. But if Apple stock price stays the same or drops during that time, my options become worthless at expiration and I lose my entire premium. After all, what good is the right to buy Apple at $180 if Apple is trading at $150?
But not only can you buy calls on a stock, you can sell them as well. The upside of selling calls is that you collect a premium upfront. However, selling calls on stocks that you do not own can be extremely risky as your downside is truly unlimited.
For example, if you sell a call option on Apple at $180 per share you are giving someone the option to buy it at that price no matter what the price is. And if Apple skyrockets, you would be forced to go to the open market, buy the share of Apple at the market price, and give the option buyer that share of stock for only $180 per share. If Apple trades at $380 six months from now, you would lose $200 for every share of stock. If it trades at $580 you would lose $400 per share and so on.
However, if you actually own a share of Apple stock, the downside of selling a call becomes limited. If Apple stock increased, you would not have to go to the market and buy the stock at the market price because you already own it. Instead, you could just turn over your share of Apple to the call buyer in exchange for the strike price. In this case, you would sell your Apple share for $180 which is more than it is trading at today. And you get to keep the premium you collected when you sold the call as well.
So, the primary upside of selling a covered call is that you get income upfront. This can be very appealing if you have already realized a big profit on a stock and are nervous about losing that gain. And you can pick a strike that is above the current price. Even if you are forced to sell your stock at expiration of the call, you are selling it at a price that is higher than you could sell it at today.
The primary downside of selling a covered call is that the stock will continue to rise above the strike price of the option and you will miss out on any gains above that price. In addition, selling a call limits your ability to sell the stock while the call is still outstanding as you would never want to have outstanding a call where you do not own the stock. If you wanted to sell the stock, you would need to buy back the call potentially at a higher premium than you collected.
Despite these drawbacks, I think covered call writing can be a way to generate income while still benefiting when stocks rise. I would be conservative when buying your first options by setting the strike high and choosing a short time to expiration so as to understand how these securities work.
Of course, this will limit the premium you collect but it will be a good first step into entering the world of options.
And finally, remember to never sell call options on stocks that you do not own. I would advise working with a financial professional when buying and selling these more complex securities. ¦
— Eric Bretan, the co- owner of Rick’s Estate & Jewelry Buyers in Punta Gorda, was a senior derivatives marketer and investment banker for more than 15 years at several global banks.
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