Forex 101: How To Boost Your Stock Returns
An options strategy called Covered Call Writing is a conservative strategy designed to reduce risk and increase income when investing in stocks. Briefly stated, stock options are contracts in which you buy or sell the right to buy or sell. Although there are eight types of options contracts, we’re interested here in low-risk “Covered Call Writing.”
Understanding the Covered Call Strategy
The core principle behind covered call writing is to generate additional income from stocks you already own. It’s a strategy favored by investors who are looking for a steady stream of supplementary earnings on their existing stock portfolio, rather than aiming for explosive, short-term gains. By selling call options against shares you own, you are essentially giving another investor the right, but not the obligation, to purchase your shares at a predetermined price (the strike price) by a specific date (the expiration date). In return for granting this right, you receive an upfront payment known as a premium.
Here’s how it works: Say it’s August and you buy 300 shares of XYZ stock at the price of $48 per share. XYZ pays a quarterly dividend of 50 cents per share. Therefore, if the price never moves, you’ll earn 4.2% per year.
Putting It Into Practice: A Step-by-Step Example
At the same time, you would participate in Covered Call Writing. To do so, you would “write three January 50 Calls.” This means you are selling (“writing”) the right for someone else to buy the stock from you (they “call” it away) between now and the third Friday of January at the specified price of $50. (All contracts expire the third Friday of the month.)
Each contract represents 100 shares, hence three contracts. The buyers pay you a fee (called a “premium”) of $3.5 per share, or $1,050. (The premium is based on the amount of time until expiration and the spread between the current price and the “strike price,” in this case $50. Therefore, the premium changes constantly.)
Analyzing the Potential Outcomes
Assuming you don’t cancel, only two things can happen next: The contract will get exercised or it will expire worthless in January. Either way, you keep the $1,050. Clearly, this strategy can yield big rewards. Among the advantages are:
- You are establishing a profitable sell price the day you buy the stock. If exercised, you are guaranteed a profit.
- You reduce risk because the premium received in effect reduces the net price you paid for the stock.
- Your annual yield is boosted far above that of the dividend alone.
Weighing the Advantages and Disadvantages
While the covered call strategy offers compelling benefits, it’s crucial to understand its limitations. For one, you are capping your potential upside. No matter how significantly the stock price increases above the strike price, you won’t profit from those gains beyond the $50 strike price if the option is exercised. This is a critical trade-off to consider.
You can sometimes mitigate this by buying back your option before expiration, effectively canceling it out. This might be a wise move if you anticipate a substantial rally in the stock price and wish to participate in those further gains. However, this action incurs additional transaction costs and may not always be economically favorable.
Furthermore, you have not eliminated the risk of the stock price declining. The premium received offers a slight cushion, but if the stock drops significantly, the option will likely expire worthless, leaving you with the loss on the stock itself. For instance, should XYZ drop by $25, your option will not be exercised – a small consolation, as you still bear the market risk of owning the stock.
Diversifying Your Risk Mitigation Strategies
To protect yourself against substantial price drops, you might consider purchasing put options. For example, you could “buy a January 45 Put.” This would give you the right to sell your stock for $45 per share, regardless of the market price, providing a floor for your losses. This strategy is the opposite of writing a call option; it’s designed to minimize potential losses rather than enhance income from existing holdings.
Selecting the Right Stocks for Covered Calls
Because of the inherent price risk, it is advisable to select high-quality, blue-chip stocks for writing covered calls. These stocks should ideally fit your budget, possess a stable trading range, demonstrate solid fundamentals, pay attractive dividends, and exhibit good long-term growth potential. The stability of the underlying stock is key to the success of this strategy. Volatile stocks introduce a higher degree of unpredictability, which can complicate the management of your option positions.
Important Considerations Before Trading Options
Covered Call Writing should not be viewed as a primary reason to buy stocks, but rather as a supplementary strategy for investors who already own them. Before opening any options trading account, it is highly recommended that you read “Characteristics and Risks of Standardized Options.” This informative booklet is published by The Options Clearing Corporation in cooperation with NASD and all major U.S. stock exchanges. You can obtain a copy from any reputable broker or financial advisor.
Understanding the intricacies and potential pitfalls of options trading is paramount. While strategies like covered calls can enhance returns, they require careful consideration of your investment goals, risk tolerance, and the specific characteristics of the underlying assets and options contracts.
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In conclusion, the Covered Call Writing strategy can be a valuable tool for stock investors seeking to boost their overall returns by generating income from their existing portfolio. By carefully selecting your stocks, understanding the terms of the options contracts, and being aware of both the opportunities and risks involved, you can effectively implement this strategy to potentially enhance your investment performance.
