Getting Paid To Wait With Your Long-Term Investments

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Key Takeaways:

• Options can be tricky, even for investors with experience.  
• However, there’s one strategy even beginners can execute with minimal risk. 
• Writing covered calls can help you get the most out of a long-term position. 

You’ve probably read about using covered calls in conjunction with stocks you own. It’s a pretty straightforward strategy with relatively low risk and meaningful potential upside. So we’ll pretend you’ve heard of and read about covered call basics. 

Today, The Juice provides a quick refresher on how covered calls work, using a real-life example. 

From there, we hit the points covered call tutorials often gloss over or leave out altogether:

• Why write a covered call beyond wanting to generate income, in and of itself? 
• Exactly what is the “minimal risk” we speak of?

99 Shares Of Apple On The Wall

Except you need 100. 

Even in these days of fractional share investing, to write a covered call you need to own 100 shares of the underlying stock. 

Here’s how it works. 

You own 100 shares of Apple (AAPL). 

As of Wednesday afternoon, the stock trades for $139.23 per share. 

The AAPL $140 July 1 covered call trades for roughly $1.30. When you write a covered call, you actually sell the call option. So you’ll often see write and sell used interchangeably. Because they’re the same thing in the covered call world. You can sell one call option for every 100 shares of an underlying stock you own. 

This generates a credit to your account. 

In this case, if you sold the aforementioned call against your AAPL position, you would receive the premium ($1.30) in cash. This means your brokerage deposits $130 in your account ($1.30 X 100). 

What Happens Next?

In this example, you will be obligated to sell your AAPL shares at the option strike price – $140 – regardless of the market price of the stock if AAPL hits that number on or before option expiration day and the owner of your call option exercises their right to purchase your shares. 

Basically, you get paid to assume the risk of losing your shares. The person buying the call option you sold pays for the possibility they’ll be able to snag AAPL for below their breakeven after taking into account the cost of the call. 

So, if AAPL hits $145 between now and July 1, you will have to give up your shares for $140. You collected the $1.30 premium, which makes your breakeven $141.30. 

If AAPL falls to, say, $135 between now and July 1, you keep your shares as well as the $130 worth of premium income. 

Pretty straightforward. 

The Risks

• We noted your break-even in our example is $141.30. If AAPL drops below that price, you – on paper at least – are losing money. 
• Let’s say you don’t want to lose your Apple stock. By writing a covered call, you assume the risk that you might have to sell your shares if AAPL’s price exceeds $140. 
• For every penny AAPL goes above $141.30, you have left money on the table. At $145, relative to your $141.30 breakeven, you missed out on $3.70 worth of upside per share. 

Why Write A Covered Call? 

• You want to sell your stock for a certain price. If you bought Apple a while ago and have set a target to sell at $140, you can write a call with a $140 strike price. If you’re forced to sell your shares, you’ll do so at your target while keeping the premium income you collected when you wrote the call. So, effectively, you got paid to sell the stock. 
• You want to collect income while you wait. Let’s say you think Apple will stay below $140. You could write $140 covered calls, collect the income each time, and, as long as Apple stagnates and stays below $140, you maintain your position and generate this income. 

You can cut it less close by selecting strike prices higher than $140 and/or different options expiration dates. It all depends on your sentiment and timeframe. 

The Bottom Line: While not without risk, the downsides of covered call writing pale in comparison to other options strategies where you can lose all of your money and/or run into margin trouble in the blink of an eye. 

Writing covered calls alongside your long-term investments can generate a healthy stream of income. If you select the right strike prices, expiration dates, and the underlying stock behaves the way you expect it to, you can hang onto your shares at the same time as collecting meaningful income.

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