Introduction to Writing Covered Calls for Income


Writing covered calls on my stocks is a key part of my personal investment strategy in my IRA accounts. When you write a covered call, you collect a premium in which I prefer to "call" income, because that it what it is. At my stage of life, I am all about generating income. 

So in my portfolio, I receive 2 forms of income: dividends and premiums. These incomes allow me pay for my day to day expenses like utility bills for my home. 

But, what is a covered call and how do you get those premiums?

A covered call is a trade in which the writer of call options owns a stock and sells options versus that stock in order to generate income.  

You can write 1 covered call per 100 shares of stock you own. So if you own 500 shares of a stock, you can write up to 5 covered calls. 

If each call paid $1.00 in premium, you would receive $500 in total premiums if you wrote 5 covered calls.  ($1.00 premium x 5 covered calls) x 100 = $500 of income. This money is paid to your account immediately.   

EXAMPLES

After doing writing a covered call, 4 things can happen. Let's use the well known stock of Johnson & Johnson (JNJ) as an example. 

Let's illustrate this with a real world example:  Suppose you own 100 shares of JNJ and are going to write a covered call on your shares.  JNJ is currently trading at around $125 a share.  January call options with a strike price of $135 are currently worth around $3.50.  If you write (sell) a call, you automatically receive $3.50.  Lets see what happens to the stock in different situations.

Situation one: The price of JNJ stays at $125 through January.  The call option expires without being executed.  You keep your stock, and the $3.50 you got for the call option.  Your payoff is $3.50.

Situation two: The price of JNJ falls to $100 in January.  The call option expires without being executed.  You keep your stock (now only worth $100), and the $3.50 you got for the call option.  Your payoff is -$21.50.  

Situation three: The price of JNJ rises to $135.  The holder of your call option executes it.  You sell the call-owner your stock for $135 and keep the $3.50 you got for the call option.  You have $138.50 in cash.  Your payoff is $13.50.

Situation four: JNJ has a blowout quarter and the price rises to $205 per share.  The holder of your call option executes it.  You have to sell the call-owner your stock for $135 even though its worth $205.  You still keep the $3.50 for the call option.  You have $138.50 in cash.  Your payoff is $13.50, but the holder of the option just made 20 times his investment.

CONCLUSION

This is obviously a very brief introduction to covered call writing. If you have interest in writing covered calls, I would STRONGLY suggest that you do further reading on all aspects of this strategy. 

However, this strategy is one that I use quite heavily for my dividend portfolio. In each case above, the write of the calls gets to keep the income they received. That income is yours to keep and to use no matter what your stock does. For me, it is all about the income. 

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