NEW YORK (TheStreet) -- I wrote an article for TheStreet on Tuesday detailing how investors can make sensible options trades to maximize the income out of dividend-paying and non-dividend-paying stocks. I acknowledged one of the major risks associated with writing covered calls was losing your shares.
When you write a covered call, you sell one call option for every 100 shares of a stock that you own. You can also execute a buy-write to establish a covered call. This simply means you open the long stock and short option leg of the trade at the same time in one transaction. In either case, you collect the premium, as a credit to your account, of the call you opted to sell. You keep that income no matter what happens. If the price of the stock moves past the strike price of the call you sold, you could have your shares called away by the party that is long the call you are short.
This all becomes clear as we look at an example.
Apple is an excellent stock to illustrate this strategy. If you own at least 100 shares of AAPL, you can generate some serious income from the position. Too many investors overlook the potential of this relatively simple method.
Prior to Apple's dazzling report on Tuesday, you might have decided to hedge your position just a bit by selling a covered call. On weakness in a long position, this is usually a sensible move. Like a dividend, covered call income helps offset any underperformance in the stock. With AAPL trading around $560 on Tuesday, you could have sold the AAPL May $600 call and collected about $9.90. That's $990 that you keep no matter what happens.
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Imagine repeating that process on a monthly basis. That's an excellent supplemental income. For some, it represents a second income. For others, it could become the primary source. I know several folks with relatively large positions in AAPL who literally live off of covered call income, just as some investors pay expenses and such using dividends.
When you write a covered call, you always run the risk of losing your shares. This scares many investors. In some respects, it probably should. In the AAPL example, maybe you picked the $600 strike because you expected weakness, stagnation or only moderate upside in the stock post-earnings. Clearly, anybody who doubted Apple even a little this quarter was wrong (present company not excluded).
AAPL soared to $600 in after-hours trading. And chances are it will hover around that level or blast far past it between now and May's options expiration. But you will not necessarily lose your shares prior to expiration just because AAPL trades above $600. You could get them called away, but there's an equally as good, if not better chance, that you will not. If, however, AAPL trades above $600 at expiration, you are almost certain to have your shares called away. Brokerages automatically exercise an ITM option contract unless the contract owner instructs them otherwise.
If you're concerned, you could always buy the covered call back. This can turn into a money-losing proposition, though. Let's say the call you sold for $9.90 trades for $13. When you buy it back at that price, you end up losing $3.10, or $310. If AAPL retreated and the call option followed (I speak theoretically here because options do not always follow the trajectory of the underlying stock) and dropped to, say, $8, you could close the trade and bank a gross profit of $1.90, or $190.
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Personally, I am not a big fan of buying covered calls back after they have run away from me. This was a major topic of discussion last week in the Options Investing Newsletter I publish with fellow TheStreet contributor Robert Weinstein. Robert tends to feel a bit better about closing a covered call for a loss, but he's more of a short-term trader than I am.
When I select a strike to sell, I make sure I am happy with where I capped my return in the event I get my shares called away and the stock exceeds the strike price. If I get assigned, I happily give up my shares and bank a meaningful gain on the overall trade (realized gains on the stock and option leg of the trade). I like the sound of that much better, as a long-term investor, than taking a loss on the covered call to salvage my shares.
At the end of the day, I can always get my shares back. In the AAPL example, I now have at least $60,990 sitting in my account. When my shares got called away, I sold them for $600. On one covered call, that's 60 grand. If my cost basis on AAPL was $500, I turned a 22% profit on the trade, which equates to $10,990 in real dollars before transaction costs.
I could put that money to work and buy AAPL back on the spot. I could wait for the inevitable pullback and buy on weakness. Or, even better, I could turn around and sell an AAPL put, which obligates me to purchase AAPL at the strike price of the contract in the event I get assigned. This represents another way to generate income. As with a short call, when you go short a put, you collect the premium on the option as a credit in your account.
You have some control over whether you get assigned. Plus, you can set your strike price on the basis of your sentiment. If you expect a pullback, go for an OTM put. If you expect some strength, go ITM, which will also bring in more income. There are many ways to go about this type of trade.
Later in the week, I will discuss the ins and outs of selecting a strike when you sell a put in an attempt to get long a stock.