The Fine Art of the "Covered Call" Those are the basics. But let's now focus on the income strategy of selling covered calls. As I just described, each call option contract gives the buyer the right, but not the obligation, to buy 100 shares of the underlying stock at the strike price by a certain date. Since you're selling the call, the buyer pays you for that right - a payment known as the "premium." If the stock stays below the strike price - or if the buyer does not "exercise" the option to buy the stock at the strike price, which they would only do if it's favorable to them - the option expires worthless and you, the seller, keep 100% of the premium. But what if the opposite happens? What if the price of the stock climbs above your strike price and the buyer exercises their right to buy the stock? The worst thing that can happen here is that you sell your shares - 100 shares per contract. Here's an example. Suppose you want to trade a covered call option on Netflix (Nasdaq: NFLX) to earn some income and reduce your cost basis. So, hypothetically speaking, let's say you could buy 100 shares of Netflix at $100 and then sell the $110 covered call option expiring next Friday, August 30, for $1.00 in premium. (To be clear, this is a purely hypothetical example using simple numbers to make it easier to understand.) When you do this, $100 in premium ($1.00 x 100 shares) hits your account. If Netflix trades up to $110 by next Friday, the buyer will have the right to exercise their call option contract and buy your 100 shares at $110 apiece. And since you received $100 in premium, your cost basis on your Netflix position is effectively $99 per share. Your best-case outcome is when the contract expires worthless. You pocket the premium (ka-ching!) and you keep all the shares of your stock. The "worst-case scenario" is that the buyer executes the option and buys - or "calls away" - your Netflix shares for $110. In this case, you would profit $11 per share on your Netflix position for a total profit of $1,100. The only risk is limited to some potential opportunity loss. Since you already own shares (100 shares per option contract) you may miss out on some gains as the stock moves above your strike price. But you'll still pocket the premium and bank a capital gain by selling the stock for more than you paid for it. That is why it's always a good idea to sell your covered calls at a higher price than what you initially paid for your shares. The worst-case scenario here is that you collect premium (which you get to keep no matter how the stock's price moves) for selling the option contract... AND you sell your shares at a profit. In other words, getting paid to profit: the best "worst-case scenario" I've ever heard of. Even better, you can keep doing this over and over again by selling covered calls against the stocks you own for as long as you like - provided the contract is never exercised. If you're new to options, I can't emphasize enough that selling covered calls is the safest way to dip your toe in the water. But you should be certain that you have 100 shares of stock for each contract you sell. Selling a contract without owning shares is called selling a "naked call," and that can be incredibly risky. If you want to step into the options market, check your portfolio for any large-cap stock you own 100 shares of, and look up the options chain for some juicy premium you can earn. To learn how to generate "income on demand," check out my "Brokerage Bonus Cash" Summit on Tuesday, August 27, at 8 p.m. ET with Chief Income Strategist Marc Lichtenfeld and Chief Investment Strategist Alexander Green. The event is entirely free to attend. Simply click here to register. All the best, Keith |
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