Equodity

Covered calls allow you to generate additional income on the stocks that you already own. If you want to hold on to the security the stocks that you currently own and generate additional income a covered call is a way to do it. There is a risk associated with this strategy, like there is with all strategies, but I will cover that. To start a covered call is selling a call option for every 100 shares you own of that particular company. The reason the ratio is 1:100 is because every one option represents 100 shares.

So if you own 150 shares of stock, you can cover 100 of them with one option, it is not advisable to sell two options in this situation though, because if your stock grows faster then expected and you get assigned you will have to buy an additional fifty shares at the market price to cover the full obligation of the second call. In other words you sold half a contract naked, please look what selling naked means naked means.

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Speaking of selling naked the covered call strategy has a very similar risk graph to that of naked selling calls. That is because you are capping your potential earnings at the strike that you so your call option. If the company who’s stock you own goes bankrupt you can loose your entire investment and you would keep just the amount of the call you sold. However, the chances of that happening are pretty slim and you would have probably gotten out of the company you own by the time the stock goes to zero. Remember this is still a bullish strategy, this is a way to generate additional income on slower moving stocks and not a way to capitalize on stocks that you are bearish on, in the case were you are bearish you will want to look at a bearish strategy.

Lets look at an example. Exxon Mobile (XOM) is a great one for this strategy. The stock has been a benefactor of the higher oil and gas prices of late, but is so huge that moving this giant with any sudden swings is pretty tough. The stock currently trades at 84.67 which is very close to the next strike of 85. For this example we will own 100 shares of XOM and sell 1 call. The 85 strike bid is at 1.85, which means I can now add $185 to my $8,467.00 which is 2.18% of my investment.

Again this is for just one month, compare that to the $0.35 dividend or $35 for 1 quarter and we are already doing more then 10 x’s better then the dividend. I mentioned earlier that there is a risk associated with this strategy, that risk is that the stock price moves higher then the strike you sold. If that happens, you are obligated to give your shares to the person who bought the call for $85 per share. Of course you will get the profit of .33 per share or $33 at 0.4% return on your money, plus you keep the amount you sold the option for, which is the $185 or 2.18% return, which isnt bad for a month, but the idea behind this trade is to be able to sell the call month after month, all while retaining the stocks slow appreciation over time. So we will look to the next strike which is 90. Currently that bid is at .40 or $40 per contract.

Not quite as attractive, but again, when you think about the dividend being $35 for the quarter, you are increasing the amount over return on the stock. The further out you go in strikes, the less you will make but the greater the chance that your call wont be executed. If you go out further in time, you can can sell your call for more, but there will be more trading days before expiration which gives your stock more time to go through the strike you sold.