Introduction
Writing covered calls (CCW) is a popular options strategy for individual investors and has been successful enough to attract the attention of mutual fund and ETF managers. Simply put, when you write a covered call, you are selling someone else the right to buy a stock you own at a specified price within a certain timeframe.
CCW as an Options Strategy
CCW can be a good strategy for an investor who is optimistic enough to hold the stock but not so optimistic as to expect a significant price increase. In fact, the basic idea behind CCW is straightforward negotiation: the option buyer pays a premium for the possibility of capturing 100% of any price increase above the strike price.
When to Use CCW
Many funds rely on writing covered calls as a primary investment strategy. If you have the time and willingness to trade your own money, writing covered calls is something you should consider. It is not the best investment choice for everyone.
Potential Advantages of CCW
Income: By selling one option for every 100 shares owned, the investor collects the premium. This amount is yours, regardless of what happens in the future.
Safety: It may not be a lot of money (although sometimes it can be), but any premium collected provides the stockholder with limited protection against loss in case the stock price drops. For example, when buying a stock at $50 per share and selling a call option that pays a premium of $2 per share, if the stock price falls, you are better off by $2 per share than someone who decided not to write covered calls. You can look at it from two equivalent perspectives: the cost basis is reduced by $2 a share or the breakeven price moves from $50 to $48.
Increased Probability of Earning a Profit: This advantage is often overlooked, but if you have a stock priced at $48 per share, you earn a profit any time the stock price is above $48 at expiration. If you have a stock priced at $50 per share, you earn a profit any time the stock price is above $50 per share. Therefore, the stockholder with the lower cost basis (i.e., the one who writes covered calls) makes money more frequently (whenever the price is above $48 but below $50).
Potential Disadvantages of CCW
Capital Gains: When writing a covered call, your gains are limited. Your maximum selling price becomes the strike price of the option. Yes, you can add the collected premium to that selling price, but if the stock price rises sharply, the covered call writer misses out on the chance for a significant profit.
Flexibility: As long as you are short a call option (i.e., you have sold the option, but it has not expired and is not covered), you cannot sell your stock. If you do, you will leave the option uncovered. Your broker will not allow that (unless you are a highly experienced investor/trader). Therefore, while it is not a big deal, you need to cover the call option at the same time or before selling the stock.
Loss of Dividends: The owner of the option can exercise the call at any time before its expiration. They pay the strike price for the stock and take your shares. If the option owner decides to exercise it for dividends, and if that happens before the stock’s ex-dividend date, you sell your shares. In this scenario, you do not own shares on the ex-dividend date and are not entitled to receive the dividends. This is not always a bad thing, but it’s important to be aware of the possibility.
Source:
https://www.thebalancemoney.com/philosophy-behind-writing-covered-calls-2536591
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