Trading Covered and Uncovered Call Options

Trading Covered and Uncovered Call Options

Call Option Investment; Know the Field Before Plunging In

 

Trading call options can be an effective way of generating income, but to do so, an investor needs to know the risks and benefits of covered and uncovered call positions.

 

A covered call is one in which the underlying stock is owned. A uncovered call is one in which the underlying stock is not owned.

Selling Covered Calls

 

Selling a covered call option is when the investor owns the underlying stock, and sells the call in order to generate income. An investor is speculating that the stock is not going to rise, or its value will decline. If this happens, the investor pockets the premium.

The risk is that if the stock rises substantially, and the buyer exercises his right to buy the stock, the holder is obligated to sell his shares. Good in a bearish stock and good for investors who don’t mind losing their stock position.

Example of Selling a Covered Call: Intel Corp

  • Say an investor owns stock in Intel Corp. The stock is currently at 20.18.
  • The stock hasn’t been moving lately so the owner decide to sell the Jan21 calls for .73.
  • Say two contracts were sold. Since each contract is 100 shares, the owner pockets $146.
  • The risk is if the stock advances about buyer’s Break-Even point, the buyer will probably exercise his right to buy and you lose the stock. (The Break-Even point is the strike price plus the premium, (21+ .73= 21.73)).
  • Even if the buyer exercises his right, an investor still will have made a profit of $146.

Selling Uncovered Calls

 

Selling an uncovered call is a very risky investment, and this writer does not advocate trading them. If the stock goes up past the strike price at expiration, the seller is obligated to sell the stock. Since the stock isn’t already owned , the investor has to go on the open market and buy it. If the stock has risen a lot, the seller has to but it at this high price, and even considering the premium gathered, an investor can face very high losses. Good for a supposed bearish stock.

Using the Intel Corp example, the investor is speculating that the stock stays the same, or drops below the Break-Even point If this happens the option will not be bought and the seller makes a profit of the premium.

Buying Uncovered Calls

 

Buying uncovered calls consist of buying the call without owning the underlying stock. The investor is speculating the stock will be bullish.

Example of an Uncovered Call: Amazon

 

Say an investor is interested in Amazon. It has shown fairly regular upward movement in earnings over time. Moreover, the 3rd quarter earnings are coming out October 22. An investor might speculate the stock is going to make an upward movement following the earnings report, and buy a call before the report.

  • The stock is currently trading at 94.78
  • Say an investor buys the NOV100 Call for 2.85
  • The Break-Even point is the strike plus the premium (100 plus 2.85 = 102.85) Of course, an investor is not going to hold the option to expiration.
  • This is a very short term position. Once the stock has risen on the probable good news, sell the option for an immediate gain.
  • If this premium is too costly, an investor can either go out a month or two (say, to December or January expirations), or buy a call with a higher strike price.

Buying Covered Calls

This consists of investors buying a call while owning the stock at the same time. This might be done to maintain ownership in a company, with the payout of dividends, while at the same time speculating on an increase in stock price.