Tuesday, October 28, 2008

What Are Covered Calls?

As a DIV-Net member and passionate investor in dividend growth stocks, I tend to focus on the safer side of investing. I focus on the long term and select stocks that have a strong history of growing dividends that is often regarded as a safe form of investing. Sure it has its ups and downs (as dividend investors can attest to these days), but overall it has proven to be a very successful strategy. So then why a post about covered calls?

Interest really. I love the investment process and try to understand as many strategies as I possibly can. Therefore, I have been researching the covered call concept in the past few weeks to see if there is any place for it in my portfolio. Here is how investopedia defines covered calls:

An options strategy whereby an investor holds a long position in an asset and writes (sells) call options on that same asset in an attempt to generate increased income from the asset. This is often employed when an investor has a short-term neutral view on the asset and for this reason hold the asset long and simultaneously have a short position via the option to generate income from the option premium.
As a dividend investor, I am obviously attempting to grow the income in my portfolio. As you can see by the definition, covered calls are intended to use the long positions you hold in a particular company to generate income from other investors who buy the right to your stock if it hits a particular price. In other words, you get paid a premium for some level of risk.

Seems pretty simple at the high level. So I did some further research and identified this list of both pros and cons of investing in covered calls:

Pros:
  • The seller receives the premium for selling the call - this is additional income that lowers the cost basis on the long position
  • If the price remains below the strike price, the seller keeps the premium and the shares
Cons:
  • If the share price rises above the options strike price, then the sellers shares are called away and the long holder does not get to enjoy that increase in share price
  • The option seller cannot sell the long position without buying the covered call back - this reduces the ability of the investor to be nimble if the share prices drops dramatically and they want to sell the security to limit their downside loss
  • Commissions are charged on every part of the transaction - buying the long position, selling the call option, having the stock called away - this can dramatically eat away at your returns
Overall, although covered calls are a much simpler option strategy, there is just so much to consider when employing the strategy that I am not sure I have the time to employ it, in addition to the regular management of my portfolio. If you find yourself still interested, then please check out Dividend Growth Investors' guest post on my blog here.

This article was written by The Dividend Guy. You may email questions or comments to me at info@thedividendguyblog.com.

2 comments:

  1. If you're interested in learning more about covered calls you may want to visit My Covered Call Blog

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  2. This is a great article. Covered Calls has it's known disadvantages which the author points out very well. But a well disciplined covered call trading strategy can be very profitable and will beat stocks in all but the strongest bull markets. Also, any covered call trader will need some sort of tool to help him make decisions on when to manipulate his positions. A great tool can be downloaded at www.coveredcallcalculator.net

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