“Boy, I would definitely sell Apple if it reached $170 again,” a client said to me recently.
Like many people, she believed entering a limit order at that price was the logical next step. As we explained, however, writing a covered call option might be a better way to accomplish her objective. Compared to holding the stock until the target price, it’s a strategy that provides additional income without incurring extra risk.
Even though most people have heard of the idea, very few people seem to put it into practice. I believe this is primarily because most people just aren’t sure how or when to use this strategy. Fortunately, it’s quite straightforward. This tactic should be considered when you’ve decided to sell a certain position if, and only if, it reaches a certain price.
From just $107.88 $24.99 for Kiplinger Personal Finance
Be a smarter, better informed investor.
Sign up for Kiplinger’s Free Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
How it Works
The process of selling call options against a stock you own is known as writing covered calls. In doing so, you give a third party the right (but not the obligation) to purchase the underlying stock from you at any time during the contract’s term at a predetermined price.
Here are the basic components of a call option contract:
- Strike Price: The price at which the stock can be purchased from you.
- Term: The length of time until the contract expires.
- Premium: The price the holder pays you to enter into the contract.
Consider the example of the person looking to sell Apple at $170. As of late April, Apple traded for roughly $165. (Note: The option prices cited in this example are from www.cboe.com and will have changed by the time this publishes. This is not a recommendation to buy or sell stock or options in Apple Computer Inc.)
For easy math, let's assume she holds 100 shares. If she were to sell a three-month call option on her Apple shares at a strike price of $170, as of late April she would collect a premium of roughly $7 per share, or $700 in total (less trading costs). From this point, one of two things will happen:
- Apple trades at or above $170 prior to the option’s expiration. In that event, the option will likely be exercised, and the option holder will purchase her shares of Apple at a price of $170.
- Apple fails to reach $170. In this case, the option expires, and she continues to own her shares. She can continue writing options and collecting additional premiums indefinitely until the stock reaches the strike price (if ever).
Either way, writing call options provides a better outcome compared to placing a limit order, since the investor will come out ahead by the amount of net premiums collected. Under the right circumstances, the difference can be substantial.
Putting it into practice
This strategy can be applied to any publicly traded stock or exchange-traded fund (ETF) large enough to have listed options. Note that this does not work for mutual funds, which is one disadvantage of an index fund compared to an ETF.
Before you can get started, you’ll need to ensure your brokerage account is authorized for options trading. You’ll need to read an educational booklet (available online) and request the applicable paperwork from your brokerage firm.
A good place to find options quotes is the Quotes & Data tab of www.cboe.com. You’ll notice that the longer the term for a given strike price, the higher the premium you can generate. Some people choose a shorter term in hopes of writing several options before the stock reaches the strike price. Others choose the longest term possible in order to maximize the up-front premium and reduce the effort involved.
Note that writing call options does not have to be an all-or-nothing proposition. For example, you can write multiple options with a series of staggered strike prices or terms, or write options on a portion of your shares. Just be aware that option contracts are typically sold in bundles of 100 shares each, which can limit your flexibility if you have a small position.
Also, as a seller of call options, please be aware that you will not be eligible to participate in gains past the call option’s strike price, and that shares may not be sold during the term of the call option’s contract. Additionally, writing call options limits the opportunity to profit from an increase in the market value of stocks.
Before taking action, you’ll want to read up on some of the particulars, including taxes, settlement procedures, etc. You can find several resources in the education section of the CBOE website that can help you get started.
The takeaway
Review a list of your positions, and ask if you would sell any of them if they reached a certain price. If so, now you have a way to potentially put some extra cash into your pocket.
Options are not suitable for all investors. Typically, commissions are charged for options transactions. Investments are subject to risk, including the loss of principal.
-
Dow, S&P 500 Slip on December Rate Cut Worries, Nvidia Boosts Nasdaq: Stock Market TodayNvidia became the first company ever to boast a $5 trillion market cap, but it wasn't enough to lift the Dow and the S&P 500.
-
Where You Choose to Stash $100k Now Comes with a Big Opportunity CostThe Fed recently cut rates. Here's where to maximize your savings while rates remain higher.
-
I'm a CPA: Control These Three Levers to Keep Your Retirement on TrackThink of investing in terms of time, savings and risk. By carefully monitoring all three, you'll keep your retirement plans heading in the right direction.
-
Debunking Three Myths About Defined Outcome ETFs (aka Buffered ETFs)Defined outcome ETFs offer a middle ground between traditional equity and fixed-income investments, helping provide downside protection and upside participation.
-
This Is Why Judge Judy Says Details Are Important in Contracts: This Contract Had HolesA couple's disastrous experience with reclaimed wood flooring led to safety hazards and a lesson in the critical importance of detailed contracts.
-
A Lesson From the School of Rock (and a Financial Adviser) as the Markets Go Around and AroundIt's hard to hold your nerve during a downturn, but next time the markets take a tumble, remember this quick rock 'n' roll tutorial and aim to stay invested.
-
I'm a Financial Pro: This Is How You Can Guide Your Heirs Through the Great Wealth TransferFocus on creating a clear estate plan, communicating your wishes early to avoid family conflict, leaving an ethical will with your values and wisdom and preparing them practically and emotionally.
-
To Reap the Full Benefits of Tax-Loss Harvesting, Consider This Investment Strategist's StepsTax-loss harvesting can offer more advantages for investors than tax relief. Over the long term, it can potentially help you maintain a robust portfolio and build wealth.
-
Social Security Wisdom From a Financial Adviser Receiving Benefits HimselfYou don't know what you don't know, and with Social Security, that can be a costly problem for retirees — one that can last a lifetime.
-
Take It From a Tax Expert: The True Measure of Your Retirement Readiness Isn't the Size of Your Nest EggA sizable nest egg is a good start, but your plan should include two to five years of basic expenses in conservative, liquid accounts as a buffer against market volatility, inflation and taxes.
