As you read in the previous article (What is a call option?) SELLING call options against stock you already own is a conservative way for a ‘home investor' to generate more income.
But how does it work?
Let's use an example.
On Jan 1st 2008, you buy 400 shares of AT&T (Symbol T) for $30.00 per share.
A Feb 2008 $32.50 call option for T is trading at $0.50. You sell 4 x Feb $32.50 calls (remember each call option is for 100 shares) and receive $200.00 (400 x $0.50).
If the stock is still at $30.00 per share when the Feb $32.50 expires (third Friday in Feb), the calls expire worthless and you keep $200.00 (or 1.67%). So effectively, now the stock cost you $29.50 per share ($30.00 - $0.50). You can now do the same thing again and sell Mar or Apr $32.50 calls.
If the stock goes down to $28.00 per share when the Feb $32.50 expires, the calls expire worthless and you keep $200.00 (or 1.67%). So effectively, instead of losing $2.00 per share ($30.00 - $28.00) IF you were to sell the stock, you would be losing $1.50 per share ($2.00 - $0.50).
If the stock goes up to $34.00 per share when the Feb $32.50 expires you basically have 2 choices.
- Let the calls be exercised by the person you sold them to, and you would have to sell the stock for $32.50 per share. This is referred to as the stock being called away. Remember that you bought the stock for $30.00 and sold it for $32.50, so you have a $2.50 per share profit from the stock, plus you keep the $0.50 from selling the call options. So your total profit is $3.00 per share, or 10%.
- You could buy back the $32.50 calls you sold for $1.50 per share, thus taking a loss of $1.00 per share on the calls. However, you have a profit of $4.00 per share on the stock ($34.00 - $30.00). So your total profit is $3.00 per share ($4.00 profit from the stock minus the $1.00 per share loss from the calls).
Which of the above two choices is best? Generally speaking, for tax purposes, choice #2 is best as you are not realizing any gains as you haven't actually sold the stock yet (where with #1 you have, and will have to pay capital gains tax on your profit). In fact, with #2 you are realizing a loss (buying back the calls for a loss) which you could use to reduce your taxes. However, if for some reason you feel the price of the stock may go down, #1 is best. It is better to pay tax of your gains than to watch the stock drop back to $30.00 and have your gains evaporate.
Now that you know what a Covered Call is, and how to use them, you should now read how to enable your brokerage account for options trading.
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