It's easy for new investors to dismiss options trading as "too risky." And that's perfectly understandable.
But once you learn some options trading basics, it can become a valuable source of income. Today, we're going to go over writing covered calls for beginners.
The funny thing is that options, when done correctly, can actually lower your risk. They can even provide a stream of income to improve your portfolio's total return.
As we said, however, let's start with the basics...
What Is a Call Option?
A call option is simply the right, but not the obligation, to buy a specific stock at a fixed price by a predetermined date. A put option is the same, except that it is the right to sell that stock. All of those parameters are part of the option's name.
For example, you could buy a call option on Coca Cola. The contract might allow you to buy shares of stock for $50 (called the strike price) by the expiration date of Sept. 18, 2020. The stock currently trades at about $48.
If the stock moves above $50 per share by September, you make a profit. Simple, so far.
The risk is if Coke does not rally. If it is not above $50 by September, the option will expire worthless. The good news is that you only lose the amount you paid for it, which is typically very much less than the price of the stock itself.
Now, here's a way you can better manage your risk with call options.
What Is a Covered Call?
A covered call is an option you sell, not buy, when you already own the underlying stock. Selling an option, often called writing an option, gives control to the person who buys it.
That makes it risky, because if the stock goes up a lot and the option buyer exercises the option (calls the stock away from you), then you would have to go out into the open market to buy the stock to sell to the option owner.
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Theoretically, the risk is unlimited. We'll get into the mechanics a little later.
But if you already own the stock, you avoid this risk altogether. You simply sell your stock to the options buyer - which is done automatically by your broker. Most likely, you will make a small profit on that sale. Perhaps you bought the stock at $40 per share months ago.
Not only that, you get to keep the money you received for the sale of the option itself. The only real risk is that you won't be able to capture any additional gains on the stock.
Here's how you can start selling options...
How to Sell an Option
Selling an option is just as easy as buying one. On your options broker's trading screen, you will likely see a box to enter the underlying stock. Enter the stock's ticker symbol - KO, for example.
Next, you should see a box for selecting the trade type. There will be a choice for "sell to open." That means you are writing a new option and not selling one you already have.
Then select the expiration date, strike price, and option type, which would be a call.
If you are writing an option on an actively traded stock, you can select "market order." It tells the broker to execute the trade right away at the best price. It is not recommended that you sell calls on less-active stocks, because the spreads are wider and the executions may be slower.
Place the order. You now should see a credit in your account for the price of the option.
Making This a Stream of Income
If the underlying stock stays below $50, you keep the money you took in, as mentioned earlier. The beauty is that you can do this over and over, as long as you own the stock. It is possible to create a monthly income of several hundred dollars or more without taking on much risk.
Don't forget - you can sell covered calls on more than one stock at a time. Of course, you still want to start slowly with one option until you build your confidence.
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