Covered Call Options
Trading covered call options is a conservative strategy using call options to boost an investor's income. In the correct market conditions, a trader using a covered call strategy can earn 20 percent a year or more. Successful covered call option trading requires extensive research to select stocks and call options.
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Example
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A trader has selected Microsoft -- MSFT -- as a covered call trade candidate. MSFT is at $27.10 per share. The MSFT call option with a strike price of $28 and expiration in three months is quoted at $0.80. A covered call trade is initiated by buying stock in 100-share increments and selling a call contract per each 100 shares. A net debit price is entered in the broker covered call trade screen. A covered call on MSFT could be to buy 100 shares and sell one call at a net debit of $26.30. The total cost would be $2,630 plus commissions.
Profit Potential
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Potential covered call trades are evaluated for two potential outcomes: profit-if-changed and profit-if-exercised. In the example, if the stock price does not change, the profit will be the $80 received from selling the call option divided by the $2,630 initial investment. The profit will be 3.04 percent for three months. Profit-if-exercised assumes the stock rises above the strike price and the stock is called away. In the example, if MSFT is above $28 when the option expires, the trade will bring in $2,800 from the sale of stock at the strike price. Profit is $170 or 6.46 percent.
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Downside Protection
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The sale of the call in covered call options gives downside protection from a falling share price. In the example, MSFT must decline below $26.30 before the trade starts to lose money. Covered call traders must watch positions closely to close out trades before they enter an unprofitable position. Covered call options traders make money in small increments and one large stock price decline can wipe out months' worth of profits. If the stock is below the strike price at expiration, the call will expire worthless, the stock shares retained in the account and another contract can be written during the following weeks.
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References
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