Boost Income With This Options Strategy
When it comes to trading options, you can trade a call or a put, and you can either buy or sell. But in practice, you can use combinations of various option contracts to tailor your overall market exposure to your liking.
You can use options to swing for the fences or to hedge against your existing stock positions. No matter how you want to balance your potential risk and reward, you can probably find a way to do it via options.
One simple and basic trade strategy that beginner options traders like to use is the covered call. This strategy provides income while limiting your risks from the trade. Here’s how it works.
The Call Option
A call option gives the option holder the right to purchase shares of the underlying stock at the option strike price at or before the expiration date. Each contract is worth 100 shares of the stock. Thus, if you have three contracts of the General Electric (NYSE: GE) January 2021 $6 calls, you could exercise them today and buy 300 shares of GE at $6 since GE is trading above that price.
On the other side of the trade, if you write (or short) three contracts of that GE call, if the counterparty exercises the option, you have to sell 300 shares of GE to them at $6.
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Imagine that you wrote the GE calls without owning any GE stock—called a “naked call.” If the calls are exercised, your account will be short 300 shares of GE and you will need to cover the position by buying 300 shares of GE. If GE is trading at $6.50, you would lose $0.50 a share, or $150 total on the trade. Don’t forget that you received a premium for writing the call. If the premium is more than $0.50, you still profit overall.
Since there’s no upper bound to how high a stock can go, theoretically the potential loss from a naked call is limitless. In other words, a naked call exposes you to high potential loss.
The Covered Call
If you already have 300 shares of GE and sell the same three GE calls, that’s a covered call. If the call is exercised, you merely lose those GE shares. You would not need to buy any GE on the market. You would not need to raise any additional cash to cover a naked call.
To be clear, in terms of opportunity cost, a covered call could still backfire. Let’s say GE is trading at $8 when the $6 call is exercised, your opportunity cost would be $600—($8 – $6) x200. This is because you could have sold GE on the market for $8 instead of $6. Let’s further say that you wrote the option for $1.25, for a total credit of $375, the covered call trade would have cost you $225 ($600 – $375).
Note that the $225 will not show up as a realized loss on your statement. It is an opportunity cost. Your realized gain or loss from the GE sale will be the difference between the premium plus $6 and your cost basis for GE stock.
If your cost basis for GE is $5.75 per share, your gain/loss statement will show a realized gain of $450. The calculation is: ($1.25 + $6 – $5.75) x 300 = $450.
Streams of Cash
So far I’ve only talked about a scenario where the option is exercised. As the option writer, your ideal scenario occurs when the option simply expires worthless. You are then free to write another covered call and pocket another premium. Rinse and repeat. Over time, these premiums can add up, adding additional cash to your portfolio.
Because covered calls are considered conservative, you would only need the lowest level option clearance on your account to use the strategy, including in Individual Retirement Accounts (IRAs).
If you are okay with capping your potential upside on the stock in return for some extra cash income, consider a covered call. To minimize potential seller’s remorse, it makes sense to pick a strike price at which you would likely have sold the stock anyway.
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