One popular options trading strategy is something called a “Covered Call”. This is where you short a call, but you own the stock for which the option is written. Normally if you were to short a call, you would make money as the option decreased in value, but you would lose money if the option increased in value. Shorting a call works like shorting a stock, the main difference is that option values can increase and decrease significantly in value leading to huge risk (if the stock price jumps up you could be on the hook for an unlimited loss with this strategy). Let’s dig into how a covered call works.
Every option involves a contract with the right to purchase or sell 100 shares of a specific stock. Let’s say you found a company you like, and you purchased 100 shares of that stock. That stock will sit in your brokerage account and increase or decrease in value based on how it is trading, and you will own that stock until you decide to sell it. Now let’s say that you want to make some money while holding this stock without having to sell it. You could short a call and do what is referred to as a “covered call” and minimize the greatest risk of shorting a call which is that stock price shoots to the moon and puts you owning a monstrous bill to your broker. If it sounds a little complicated or maybe too good to be true let’s break it down a little further.
Let’s say the 100 shares of stock you own are currently valued at $100 per share. This would put your total value of all 100 shares at $10,000. Let’s look at an example call and what it would mean to short for the stock you own. You find a contract to short which says you agree to sell those 100 shares for $120 anytime in the next 6 months. In exchange for that right, someone is willing to pay you $500 right now. Seems like a no-brainer, right? You get $500 deposited into your brokerage account immediately and if the contract is executed you must sell your shares for $20 more than what the stock is currently trading at. And even if the contract isn’t executed you just get to keep the $500 free and clear? Doesn’t seem like any downside, huh? Obviously, many factors would determine the numbers I used in this example including the price of the stock, the time frame, volatility, and delta of the stock (how far in or out of the money your strike price is set for). So are there any risks to this strategy?
The short answer is yes, there is always risk in any investment. However, what you are risking in this scenario is a little different than what you may think. In the simplest verbiage, what you are risking is potential future gains. How you would “lose” with this strategy is if the stock price went much higher than the strike price. Think of the example above with the stock trading at $100 with the strike price of $120. If that stock were to jump up to $200, you are forced to sell it at $120 which makes you lose out on a lot of the increase on that stock. Likewise, the person on the opposite side of your option trade is hoping the stock goes up super high so they can buy it at the lower price of $120 and it only costs them $500 for that right? Every option contract involves two people, and they are both trying to make money but only one of them will be able to. Where you protect yourself as the person doing a “covered call” is when that stock price goes through the roof, you only have to give them your stocks vs. purchasing them at whatever price they are currently trading on the open market. So that is what happens when the stock price goes up but what happens if the stock price goes down after you have done a covered call?
Great question! If you have opened a covered call and your stock price goes down the value of your shorted call increases. We know that when we “short” a stock or a call we are selling that stock or contract now and buying it back later, hopefully for a lower price so we can pocket the difference. Let’s take another look at the previous example with our 100 shares of stock worth $100 each. We received $500 to open the contract initially and instead of going up the stock price drops the very next day. The contract we just received $500 for yesterday is now trading on the open market for $200. We now have a choice to make. We can “buy to close” our position (this is how you would sell out of an options short) where we can spend $200 and eliminate our contract and our obligation to sell our stock and essentially just made $300 (but keep in mind the stock you own decreased in value as well). Some may choose to leave the position open since they don’t think the stock will ever reach the strike price. If they wait out the contract until the expiration date, they get to keep the entire $500. From here, you are free to open another covered call if you wish since you no longer must sell under that contract since you either bought it out or it expired.
Things can get a little more complicated if the stock price goes way above your strike price though. Depending on your investment strategy you may be forced with a difficult decision. Do you “buy to close” out of your covered call or do you let your option execute and sell your shares for the strike price? If you never intended to sell your shares and want to hold them long term, you may just eat the cost to cover the “buy to close” on your option (depending on where the stock price moved to this could end up costing you more than what you got for shorting the call in the first place). In this scenario, you chalk it up to a loss but at least you get to keep your shares. On the other hand, you could choose to just let the option expire and sell your shares at the strike price. You keep the premium you got when you opened the position (In our example that would be the $500) and you get to sell your stocks for whatever price you determined (in our example that was the $120 strike price). So you have made money but no longer have those 100 shares.
At the end of the day, there are no “risk-free” investment strategies, however, if you stick to a covered call strategy you can minimize risks and loss of income if you are strategic and disciplined. Always consider the amount of time you want your stocks tied up as well. If you do a covered call, you cannot (or should not) sell the underlying stock until your option expires or is bought out. If you need to sell those shares before your expiration date you may have an expensive option contract to buy out first. As always do your research and pick the investment strategy that meets your goals and risk tolerance.