What is Foolsaurus?

It's a glossary of investing terms edited and maintained by our analysts, writers and YOU, our Foolish community. Get Started Now!


Covered call

The covered-call strategy of investing involves selling call options on a stock that you also own shares of for the long term. It's a way of trying to make a bit more money out of a stock in terms of generating some income now.

Contents

Expanded Definition

For income

Suppose you own shares of Company XYZ, but expect its price to stay flat or go up only a little in the near term. That is, you don't expect it to drop or rise significantly, but trade in a relatively stable band (say between $13 and $25 for the last several years). Rather than letting your shares languish, you can sell call options on some of your shares of the stock. (Remember that a single option covers a block of 100 shares, so you need to own at least that many for this to work.) The person who buys the options from you has the right (not the obligation) to buy your shares at the specified price (called a strike price) before a specified time (called the expiration date).

Let's suppose that the shares are currently trading around $15 right now. You would write (sell) the option for slightly higher, in this case $17.50 (strike prices occur in steps of $2.50 or $5, usually, depending on the share price). You would be paid a premium for that option.

Now, if the share price stays below $17.50, then the option expires worthless and you keep both the shares and the premium (the price paid for the option) and you can do the same thing again. If the shares rise above $17.50, they will probably be "called away" -- that is, the owner of the option will exercise it and buy your shares from you for $17.50 each. You can then purchase the shares again and repeat with a different option (say, buy at $18, sell the $20 call option).

The buyer of the call option pays you for the option and you keep that premium whether the buyer eventually buys the shares or lets the options expire.

For this strategy, aim for a 7% or so return within six months (for 15% annualized) if exercised (this includes the stock price difference) or at least a 5% six-month return if not exercised.

Defense

Another use of the covered call is when there is little downside risk, but not much upside potential in the near term, either. And you want to benefit a little bit while waiting for the stock to appreciate or your investment thesis to unfold.

Suppose you own the stock as part of your core portfolio. You don't expect much to happen with the stock in the near term, but you're not ready to sell yet, either. Sell a covered call to make the waiting a bit easier. But only do this if you wouldn't be too upset if the call is exercised and you have to sell the shares anyway. And, only do it if the return is worth your while.

For a better sale price

One last use is if you believe the stock is trading at or near its intrinsic value. If you want to sell at a particular price, but want to be paid for the privilege (and don't mind holding if it doesn't work out), you can use a covered call instead of a limit sell to generate a bit more cash out of the situation. Be careful though. First, you must want to sell it at that price. And, if the stock price is volatile, just sell it. You don't want to give up the chance of selling it just for a few bucks from an option.

Risk

The risk is that the share price could jump up a lot. Say you sold the $17.50 option and the price jumped to $22.50. The buyer of the option would buy the shares from you at $17.50 and you are out the $5 difference. Of course, you still got the premium and the gain from $15 to $17.50, so all is not lost.


Related Fool Articles

Related Terms

Recent Mentions on Fool.com

Related Web Sites

  • Born To Sell covered calls tutorial and screener
  • CBOE Chicago Board Options Exchange covered calls
Advertisement