- A call option is an investment instrument that gives the holder the right to buy a specific stock at a certain date. If you own 100 shares of a stock, you can sell the right for someone to buy it from you at a preset price within a period of time. As an example, suppose the stock for the company Shakey Savings Bank, which you own is currently at $19.50 per share, and the price being paid for selling one option contract is 75 cents per share (called the "premium") with a "strike price" of $20 (the price at which you are willing to sell the stock) and an expiration date of two months from now. One option contract represents 100 shares of stock, so if you sold a call option on your stock, you would receive $75 (75 cents times 100 shares, less any commission). By selling a call option, you would be giving the right for someone to buy your 100 shares of Shakey Savings Bank for $20 a share between now and the expiration date. You receive $75 for selling this right. If time passes and no one takes you up on your offer, you get to keep the $75, and you still own the stock. Should the stock go over $20, someone will buy that option so they can purchase the stock at the lower price of $20 per share. You keep the $75 premium, and you'll be paid $20 per share for your stock. If you bought the stock at a lower price earlier, and you'll also make a profit on that sale.
- When you sell a covered call option, you make money from the sale, no matter what happens. If the call is exercised and you are "called out," that is, your offer to buy your stock at $20 a share is taken, you make an additional profit on the stock sale (assuming you purchased it for less than $20 a share), but you lose the stock, and will no longer hold it in your portfolio. If this is a stock you really want to keep for the long term, as many investors do with stocks in their portfolio, you would now have to buy 100 shares of stock back again, but at a higher price. This could erase any gains you made by writing the call and selling the stock.
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Selling covered calls is a great strategy, but you risk losing the stock.
The best technique for selling a covered call option on a stock that you want to keep long-term in your portfolio is to buy a "put" option as protection against being called out. This insurance technique reduces the profit made from selling the covered call, but it ensures that the underlying stock can be purchased back at a lower price so you can keep it in your long-term portfolio. This technique is called a "protective put" or a "collar" strategy. - To illustrate this technique, suppose you purchased 100 shares of a company sometime ago, for $60 a share. Your plan is to hold this stock in your portfolio for many years to participate in its growth. To make money in the meantime, selling covered calls every few months can generate additional income, but there is always the risk that a call will be exercised and you'll have to give up the stock. Suppose you sell a covered call with an expiration date in two months at strike price of $65, with a premium of $1.40, giving you $140 for the sale ($1.40 times 100 shares). At the same time, buy a put option, also with an expiration date in two months and a strike price of $65, for a cost of $125. Your profit for the play is $15 ($140 minus $125). You made less profit than if you had simply sold a covered call, but this technique ensures you can replace that stock. Every few months you can use this technique again, and continue to bring in additional, though small, income while holding your stock long-term to benefit from long-term appreciation.
