Covered calls can generate consistent income for almost any trader's portfolio if executed properly. The basics of the trade are fairly simple. The holder of a stock sells a call option against their shares giving up the right to further price appreciation above a certain strike price of the call. This contract has a finite term.
You may be wondering why a stock investor would sell their right to future share appreciation. If you have ever heard the phrase "pigs get slaughtered" you may know the answer. You must know when to hold and when to sell. Entering into a covered call trade gives you some certainty that you are at least being compensated for holding your shares, but not getting too greedy when the share price rises.
Some investors will also use covered calls when attempting to trade a stock that is going ex-dividend. Or, they may believe a stock is in for a mild correction and they don't want to let shares go because of other reasons like capital gains tax liabilities.
In general, the covered call gives an investor an additional tool in their investment strategy.
Investors in Monster Worldwide, Inc. (NYSE:MWW), Groupon, Inc. (NASDAQ:GRPN), and Trina Solar Limited (NYSE:TSL) should consider an out-of-the-money covered call to increase portfolio income and profit from any potential price gains.
A November 2012 expiration covered call in Monster Worldwide could yield a potential profit of 13.3% over the next 44 days when holders of the stock sell the $$8.00 call option. If the stock trades above $8.00, shares will automatically be sold at the expiration date. If shares trade below $8.00, the seller of the call gets to keep the $0.85 option premium. If shares fall to $7.06, the investor reaches a break-even point on the trade.
Investors in Groupon could profit from a similar covered call trade by selling the November $5.00 strike price call option for a premium of $0.40. If the share price rises above $5.00, the stock will automatically be sold for a profit of 15.7% over a holding period of 44 days. That's a potential annualized return of 128.79%. The break-even price on the trade is $4.32.
Trina Solar investors may consider a covered call trade with a November 2012 expiration as well. By selling the $5.00 strike price call option against shares they hold, they will receive a premium of $0.19 for taking the position for 44 days. If shares are called, the profit will be 14.7%. If shares trade below $5.00, then the investor keeps portfolio income of about 3.4%. The break-even price on the trade is around $4.36.
These trades should be considered hypothetical and as part of a larger financial strategy. Exercise your own due diligence surrounding the underlying stocks and do not enter into any options trade without understanding the complexities of the transaction. The calculations provided above are generated through an online calculator provided by the Options Industry Council.