Equity options are products that are used increasingly because they add more flexibility to a portfolio. We gave a brief crash course for options and one of the discussed strategies is covered calls. For many investors, this can add a few percentage points to your net return on an annual basis. The most important thing to remember is to remain disciplined (as most trading strategies would call for) and not get greedy.
How it works
If you own a typical portfolio, you probably own several stocks. In our example, we will look at someone who owns Royal Bank of Canada (RY) stock. As I write, it trades at $55.20CAD. Imagine an investor who owns 1000 shares of RY and does not intend on selling these shares for the moment.
In a covered call strategy, this investor will sell 10 contracts which are currently worth $0.65 (each option contract is equivalent to 100 shares). This will entitle the buyer of the options to buy shares at the strike of the option.
A covered call is basically selling the right to buy your stocks to someone else. We will take a look at APRIL 60 CALLS. This gives the buyer the right to buy RBC stocks at $60 on expiry. And so the investor might have to sell his stock at $60. For this option sold, you receive $0.65 x 10 (contracts) x 100 (options multiplier) = $650
-If RBC is worth $58 at expiry, you will have received the $650 and the options will become worthless to the buyer – you can restart the strategy.
-If RBC is worth $60 at expiry, it will be the exact same thing.
-If RBC is worth $62 at expiry, you will have received $650 and will be forced to sell your shares at 60$.
As you can see, as long as you select a “low strike”, you will end up getting more money than if you only had your stock position.
Even if your shares do climb a lot and you miss out on some of it, you will have profited.
Upside and downside
The upside is that if you select the correct strikes, you will add cash flow to your portfolio. You can do this 3-4 times per year on most positions and make a few thousand bucks.
The main downside is that if the stock goes up by a lot very quickly, you will lose out on some of the rise. For example, if the stock goes up 15% in 3 months, you could end up making only 7-8%… Which is not that bad is it? That is why this is called a covered call. You do not have much risk besides losing out on potential gains, which are extraordinary. I know of many managers who are able to get big returns every month thanks to this method.
One of the main risks of this strategy is becoming greedy. If you want to collect too much, you will trade lower strikes and by doing that you:
-increase your payout (interesting)
-Increase the chances your option will be called (and that you will lose on potential gains) – less interesting.
Overall, this is a very safe strategy because it has so little downside risk. It must be used with caution like any other trading strategy.
Here is a graph of the covered call payoff strategy:
Please feel free to ask questions, I know this is not straightforward but used with caution, it can make a big difference to your returns.
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