The following is an easy to understand example of
how the "covered call" strategy works.
By using the covered call strategy, you can......
* Lower your cost on stocks you already own.
* Buy stocks at a "discount" to their current price.
* Make as much as 10-20% per month.
* Cushion yourself in case the market crashes.
* Make money when stocks go up, sideways or slightly down.
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Karen buys 100 shares of IBM at $90 per share (total cost $9,000)
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Karen's neighbor Gary, pays Karen a visit and after a short conversation about IBM, Gary offers to pay Karen $10 per share ($1,000) to sign a contract (contract will expire in 1 month) stating that she is willing to sell her 100 shares of IBM for $95 per share ($9,500). According to the contract Gary has the RIGHT to buy the stock from Karen at $95 per share ($9,500), Gary is NOT OBLIGATED to buy the stock at $95 if he doesn't want to.
SCENARIO A |
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The one month contract is about to expire and
IBM's price is above $95. Gary comes knocking on Karen's door, takes Karen's certificate of 100 IBM shares and pays her $95 per share($9,500).
Karen made $15 on a $80 investment (18.7%)
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SCENARIO B
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The one month contract is about to expire and IBM's price is below $95. Gary lets his contract expire worthless (why should he pay Karen $95 for IBM when he can buy it for cheaper in the market ?). Karen gets to keep her 100 shares of IBM.
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In both scenarios, Karen lowered her cost basis on her shares of IBM as soon as Gary bought the contract from her. In essence, the stock could have stayed the same price or even gone down slightly, and Karen would have still made money.
Karen wrote a "covered call". It is considered "covered" because she owned the shares of stock prior to signing the contract with Gary, therefore if Gary came knocking on her door requesting "his" shares of IBM at $95, she could sell it to him without having to actually go into the market to purchase the shares herself (possibly at MUCH higher prices). Since she owns the shares, she is considered to be "covered".
A "covered call" investor can make money in up, neutral and even slightly down markets. It is important to remember that once a contract expires and the stock doesn't get taken ("called") away from you, you can continue to lower your cost basis on the stock by selling yet another call against your stock position. |
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