Tuesday, September 25, 2007

How to Sell Covered Calls, Part 1

There is a way. By selling a call when you also own 100 shares of the underlying stock, you cover your position. If the option is called away by the buyer, you can meet the obligation simply by delivering shares that you already own.

You enjoy several advantages through the covered call.

You are paid a premium for each call that you sell, and the cash is placed in your account at the time you sell. While this is also true of uncovered call writing, the same risks do not apply. You can afford exercise because you own 100 shares of stock. Upon exercise, you would not be required to buy shares at market price; you simply relinquish ownership of the shares you already own.

The actual net price of your 100 shares of stock is reduced by the value of the option premium. The covered call discounts your basis because you receive cash when you sell the call. This gives you flexibility and downside protection, as well as greater versatility in selling calls with high time value.

Selling covered calls provides you with the freedom to accept moderate interim price declines, because the premium you receive reduces your basis in the stock. Simply owning the stock without the discount means that declines in the stock's market value represent paper losses.

By selling calls against appreciated stock, you are able to augment profits and, in the case of exercise, build in a capital gain as well.

The disadvantage to covered call selling is found in lost opportunity risk that may or may not materialize. If the stock's market value rises dramatically, your call will be exercised at the specified striking price. If you had not sold the call, you would benefit from higher market value in shares of stock. So covered call sellers trade the certainty of premiums received today, for the potential lost profits in the event of exercise.

Tip: The major risk associated with covered call writing is the possibility of lost income from rising stock prices. But that might not happen at all; when you sell a call, you accept the possibility of lost capital gains income in exchange for the certainty of call premium income.

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