Covered-call options are not a new instrument in the stock market, but they’re an increasingly popular way of generating income for long-term portfolios because they’re seen as relatively low risk. By speculating with already-owned stock, there is a chance of generating profit.
Here’s how they work.
First, what is a call option?
A call option is a contract that gives the buyer of the option the right to buy a certain amount of stock (or other investment instrument) at a certain price within a certain frame of time. The option buyer pays a premium for this opportunity. That’s the option price.
Importantly, this right to buy is not a promise to buy. What that means is that if the price of the optioned stock falls below the price written into the option, the option owner simply opts not to buy the stock and thus loses no money.
It’s always up to the owner of the option whether to exercise the rights offered by the contract. If the owner decides not to buy the stock (because, for example, the stock has dropped in value), all the owner loses is the premium paid for the option.
Options name a strike price (the price at which the option owner may buy the underlying stock) and an expiration date. The further away the expiration date is, the more valuable the stock option is because of its greater flexibility.
There is more time in which the stock may potentially rise in value. Thus, options decay in value over time.
What is a covered-call option?
With this type of option, the investors already own the stock for which they are writing (that is, selling) the option. That’s why the option is described as “covered.” A covered-call option gives someone else the right to buy stock you already own in your portfolio.
You collect a premium — the price of the option — and if the option expires without the buyer exercising the right to buy the underlying stock (which is what you’re hoping for), you keep the premium, and nothing else about your portfolio has changed.
The risk you’re assuming when you write covered-call options is that you might lose out on potential dividends or profits if the owned stock rises sharply in price during the option period because you are then obliged to sell it at the strike price set in the options contract.
You can potentially buy back the option itself, but you would incur a loss because the value of the option rises with the price of the stock. However, it might be that the loss here would be preferable to the loss of an increasingly valuable stock.
The option’s value for the writer is entirely in the premium. This method uses a portfolio to increase income in neutral markets (where the relative movement of stock prices is less predictable).
It also theoretically insures you against a certain amount of loss because the premium you’ve received can be deducted from the price you paid for the stock.
The bottom line
This is not a strategy for day traders or for those looking to produce a lot of income, but the covered-call option is a relatively conservative vehicle for increasing the earning potential of a long-term portfolio, one that can ride out the ups and downs of the market. Therefore, it’s an opportunity worth examining.
