Selling Covered Calls: How It Works and its Built-in Downside Cushion

Video # 2 in our new 7-part series, featuring Roger Michalski and Bryan Perry.

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How Covered Call Selling Works and its Built-in Downside Cushion

ROGER: Hi this is Roger Michalski, Publisher of Eagle Financial Publications here in Washington, DC. I’m here with Bryan Perry, the Editor of the Cash Machine newsletter. Bryan is an expert on income investing, and today we are talking about covered calls and selling covered calls, and the option premiums you can get from those, and how you can really substantially increase your income stream. So tell me, how risky is this?

BRYAN: Well, when people mention the word “options,” Roger, they typically think there is a lot of risk associated with that. But like in any market there are two-sides to every trade. If you are buying puts and calls then you are taking the substantial risk because it is a time wasting asset that most people are somewhat familiar with, and we get into that in terms of how the mechanics work.

But if you are selling calls against an underlying position, then that is basically a risk-free trade so to speak. What you are doing is basically giving someone else the right to buy your stock away from you at a higher price than where it is currently trading. And that right is worth money, and so that is what is on an option contract and you are selling that right out to someone else.

Let’s say you own 100 shares of Starbucks and it is trading at 55 and you are willing to sell an options contract that allows them to buy it away at $60… so that money you bring into your account at that very moment is then in the form of cash. So the real risk is if Starbucks goes to $65 and you have agreed to sell it at $60. You may lose some upside but you brought in some call premium… there is always risk associated with stocks and if you are along Starbucks and you get into a market correction then there is always downside risks — and that is where people should use some form of a sell discipline strategy that is associated with that.

Bringing in call premium actually reduces that downside risk because you are bringing in some extra cash and that is going to also cushion your cost basis. So, from the standpoint of risk it actually eliminates or reduces a lot of risk from the standpoint of being long-growth stocks.
And at the same time the real risk is kind of a nice risk to have, so to speak. Because if you get called away at a higher price you may have left some money on the table but you are still going to the bank with a capital gain.

ROGER: So nothing is risk-free… and is that the downside right there?

BRYAN: It really is. That is the downside because assuming that the stock does fall below the strike price that option is going to be worthless, but if you sold it for $100, $200, or $300 per contract, that money is 100% yours.

So there is always risk, again, of a market pull-back or a stock pulling back more so than the cost basis, but that is something that every investor has to determine — whether or not they want to hold their stock through certain volatile times. Selling covered calls, quite frankly, it brings in the kind of income that people are looking for. And at the same time it does take an element of risk out of being long that security because if you bring in $3 worth of option premiums and your cost is $55 on a stock, that theoretically means that your break-even point is 52.

So you can allow the stock to move roughly 3 points below before that options contract premium that you brought in becomes where the total position is in a negative position. So there are some downside cushions to bringing in option premiums and at the same time you generate income, and hopefully the stock continues to maintain in your account and not go ballistic to the upside where you leave a lot of money on the table. But that is a nice problem to have, as we say in business.

ROGER: Yeah, absolutely. A low-risk way to bring in more income… who doesn’t want that? I’m sure people are wondering how much time this would take them and if it’s easy or not. And in fact it is easy, it does not take a lot of time, and we are going to talk about that in the next video. This is Roger Michalski, along with Bryan Perry… thank you for watching the video and we will see you on the next one.

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