The covered call strategy is a great way to open a second stream of income and minimize the impact of volatile gyrations on one's portfolio.
What are covered calls?
An investor basically writes a call option (sells calls) that is backed by with the equivalent number of shares, hence the name covered call. If the stock is purchased at the same time a call contract is sold it's often referred to as a "buy write". On the other hand, if the shares are already from a previous purchase, it is referred to as "overwrite." This is the most basic and widely used strategy, which combines the litheness of options with stock ownership.
When you write a covered call income is generated in the form of the premium paid by the option buyer. If the stock trades above the strike price, then the owner will have to sell the shares at that price, if not the owner of the stock gets to keep the premium. The risk of stock ownership is not eliminated. If the stock drops significantly, then the net position will likely lose money, however, using this strategy would reduce the loss factor by the amount in premiums the owner of the shares received for each call he sold. The main risk of a covered call strategy is that the stock might decline significantly in value; in other words, the same risk any share holder bears but with the added benefit of receiving a premium for the calls you sold.
Let us look at an example
Let's say you own 300 shares in SDRL, which is currently trading at 38, and you think that there is little chance that the stock is going to hit 45 in the next six months. You can then sell calls with a strike of 45; the premium you receive is yours to keep. If in the next six months SDRL does not trade above 45 (usually the stock has to trade above the strike price on the last trading day), then you hold onto the shares as well as the premium.
Benefits of employing this strategy
Each contract trades at a premium (the higher the beta the higher the premium), and the buyer of the contract pays you that premium for the right to purchase 100 shares of the stock at the strike price. The premium is deposited immediately into your brokerage account.
1) Downside protection and reduction in Portfolio volatility
If the stock drops in value, the premium collected at least some type of return, and it can offset all or part of the loss depending on how severely the stock has pulled back. For example; if you sold a covered call against a stock when it was trading $20 for a premium of $2.50, then as long as the stock does not drop below $17.50 you are okay. In essence, you have reduced your entry price to $17.50. If this strategy is actively employed, then you could in general significantly reduce the volatility your portfolio is subjected to.
2) Predetermined rate of Return
This strategy gives you a decent idea of your rate of return on your investment will be. Regardless of what takes place you still get to keep the premium. If your shares are called away from you at the strike price, it is easy to figure your profit; this is the difference from what you paid for the stock and the strike price you sold the option, plus the premium you collected. So let's take the above example. If SDRL trades above 45, your shares are called, and you are out at 45. So your profit is 7 plus the 2.50 which you received in premium for a total gain of 25%.
If the stock starts to drop in price, you lose money on paper (much like any other share holder) when price of the stock falls in excess of the premium you received.
3) Converts a common stock into a dividend paying stock
The moment you sell the call option, the stock you own, in essence, has turned into a dividend paying-stock; if it already pays a dividend you have turbo charged your gains.
4) Repeat the process all over again
If your shares have not been called away from you, you can repeat the whole process again with the same shares of stock you own. Utilized properly this strategy can produce an income stream that can surpass the dividend paid out by that specific stock. If the stock does not pay out a dividend, you have just converted into one that does. If the stock is called, there is nothing to prevent you from buying another good stock and repeating the whole process again.
5) Buy back the call
If you sold the call for a premium of 2.50 and the call is now trading at 1.00, you could buy the call back, and you still get to keep the difference, which in this case amounts to $1.50. You could take things one step further and start the whole process again by selling calls that are fetching higher premiums. For example, you sold calls on stock X when it was trading at 37 with a strike at 40 for a premium of $2.50. The stock is now trading at 34, so you buy the call back and sell new calls with a strike at 37.50.