Covered call writing is a popular investment strategy used by many investors to generate income on their existing stock portfolio.
Covered Call is also one of my favorite options trading strategies, together with writing cash-secured put options. The strategy involves selling call options against stocks that you own, in exchange for receiving a premium payment.
The covered call writing strategy is a relatively simple one to understand. Essentially, you own a stock and sell a call option on that stock. By selling the call option, you are agreeing to sell the stock at a certain price (known as the strike price) to the buyer of the option, should they choose to exercise it. In exchange for this agreement, you receive a premium payment upfront.
If the stock price does not rise above the strike price by the expiration date of the option, then the option will expire worthless and you get to keep the premium payment. If the stock price does rise above the strike price, then you may be obligated to sell the stock at the agreed-upon price, but you still get to keep the premium payment.
For example, on April 13, 2023 Amazon stock was trading at $97.83, suppose you bought 100 shares with AMZN stock, paying $9,783, you could write one covered call option with strike price $100 and expiry on May 12, 2023 (about 30 days to expiry) for a premium of $4.15 or in total $415.
What happens next?
On the expiry date, May 12, 2023, AMZN is trading under $100 per share - options expire worthlessly and you keep premium - if AMZN trades above $100 our shares get called away
In case you 100 shares get called away you realize a profit both from the premium and price appreciation, in total $632 (415 + 217) in about 30 days. About 6.4% gain.
The primary benefit of covered call writing is the ability to generate income on your existing stock portfolio. By selling call options, you can receive premium payments which can add to your overall returns. Additionally, if the stock price does not rise above the strike price, then you get to keep the premium payment without having to sell your stock.
Another benefit of covered call writing is that it can provide some downside protection for your stock holdings. If the stock price does drop, you still own the stock and can potentially benefit from any rebound in the future. The premium payment received from selling the call option can also help offset some of the losses in the stock price.
As with any investment strategy, there are risks to consider when using covered call writing. The primary risk is that you may be obligated to sell your stock at the agreed-upon price if the stock price rises above the strike price. This can result in missed profits if the stock continues to rise beyond the strike price.
Additionally, if the stock price drops significantly, then the premium payment received from selling the call option may not fully offset the losses in the stock price.
Covered call writing is a popular investment strategy that can be used to generate income on an existing stock portfolio. By understanding the basics of the strategy, investors can decide if covered call writing is a suitable strategy for their investment goals and risk tolerance. As with any investment strategy, it's important to fully understand the risks involved before committing any capital.
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