An alternative strategy to covered calls is a buy and hold strategy where you own the stock and hope for price appreciation (and collect dividends, if your stock pays dividends).
We believe covered calls offers a lower risk alternative. In exchange for putting a cap on your upside, you get some downside protection, make money if the stock goes up, make money if the stock stays flat, and might make money even if your stock goes down a little. Let's compare the two strategies:
You bought 100 shares of ABC stock at $60.
There is a call option with a strike of 65 that someone is willing to pay $2 for. By accepting the $2 (per share) you agree to sell your stock for 65 any time before the option expires.
Buy and Hold vs. Covered Call for 3 scenarios:
Stock action | Buy and Hold | Covered Call |
|---|---|---|
| ABC goes up | You profit | Your profit is capped at $67/share (strike price + $2/share call premium) |
| ABC stays flat | You break even | You profit $2/share (amount of call premium) |
| ABC goes down | You lose | You profit if ABC goes down less than $2/share (amount of call premium), and lose if ABC goes down more than $2/share (but, and this is key, you lose $2/share less than in the Buy and Hold case) |
Notice that in the last 2 cases you come out better with a Covered Call than in the Buy and Hold case. The tradeoff for this is that in the first case you have put a cap on how much upside you can realize.
Here's the same situation with profit/loss numbers for different stock prices at expiration (where you bought 100 shares at 60 to start, and in the covered call case you sold a 65 strike option for $2):
Stock price | Buy and Hold | Covered Call | Difference |
|---|---|---|---|
| 70 | 1000 | 700 | (300) |
| 68 | 800 | 700 | (100) |
| 67 | 700 | 700 | 0 |
| 66 | 600 | 700 | 100 |
| 65 | 500 | 700 | 200 |
| 64 | 400 | 600 | 200 |
| 63 | 300 | 500 | 200 |
| 60 | 0 | 200 | 200 |
| 59 | (100) | 100 | 200 |
| 58 | (200) | 0 | 200 |
| 57 | (300) | (100) | 200 |
| 55 | (500) | (300) | 200 |
Covered Call does better than Buy and Hold in all cases up to a closing stock price of $67 on the day of option expiration. But, in exchange for that, the Covered Call writer in this example has capped his upside at $67/share.
You can set the cap (strike price) as high as you want, but the higher you set it the lower the option premium will be. If you sell near-month options then you can reset the cap once per month to a different strike (as the stock goes up or down). And each month you collect another option premium.
