As you may already know, there are two types of options: call options and put options. In both cases an investor can be either long or short each of these option types. These options can also be either covered or naked. And while many advanced option strategies have exotic sounding names, every option strategy is based on the simple idea of the buying and selling of call and put options.
For simplicity sake here is a working definition of who a call and put option buyer is. A Call Option Buyer is the buyer of a call who has the right to buy the underlying stock at a set price until the option contract expires. A Put Option Buyer is the buyer of a put who has the right to sell the underlying stock at a set price until the contract expires.
Selling a Covered Call, also referred to as writing a call, can only occur if you already own shares of the underlying stock and you sell another investor, a Call Option Buyer, the right, but not the obligation, to buy that stock at a set price until the option expires. The obvious question is, “Why would anyone want to sell their rights to their stock?” And the answer is "Any investor who wants to receive cash (the premium) that will reduce his initial investment in the security". If this activity is repeated several times and if, over time, a sufficient number of options are sold, the initial cost of the underlying security will eventually be reduced to zero.
For the uninitiated investor the idea of receiving extra income (in addition to dividends) on stocks they already own sounds too good to be true but like any options strategy there are risks as well as benefits. The intent of the options seller is to reduce those risks and enhance those benefits.
How this strategy works
Before making any trades, it’s critical to understand how this strategy works. For example, suppose an investor owns 100 shares of company "AAA" currently selling for $30 per share and he decides to sell (or write) one call (one call is equal to 100 shares of stock). The investor is contractually agreeing to sell those 100 shares for an agreed upon price known as the strike price. The premium that the investor receives is determined by a bid and ask price model but for a given stock, the higher the strike price is above the stock price, the smaller the premium is. In addition, premiums are larger for expiration dates that are farther out than for dates that are closer in. For example, an investor who chooses an expiration date three months out, the option will have a larger premium than one with an expiration date of only one month out. Luckily, for most securities there are multiple strike prices and multiple expiration dates so there's a myriad of choices for the option seller.
Let’s say in January an investor chooses to sell a covered call with a February expiration date. On the third Friday of the month trading on that option ends and on the following day it expires. At that point either the option is assigned and the stock is sold at the strike price or the seller keeps the stock. If, at the time of expiration, the price of the stock remains below the strike price the option will expire worthless and the covered call writer keeps all the money. He then has the option to sell another covered call.
This sounds simple and it is for more experienced investors. For new investors, however, it takes a little experience to find the right strike prices and expiration dates that work best for the security he's holding. New option sellers may want to initially experiment with one option contract and with different strike prices and expiration dates until they find that right combination that works for them.
I have found over the years that owning good quality stocks that allow me to sell covered calls against them can generate a series of premiums equal to, and sometimes greater than, the underlying stock’s dividend distribution. And in many cases I can double that dividend. And that's a dividend growth investor's dream.
This may just be one strategy that's worth taking the time to learn.