Covered calls are a powerful investment strategy that can help you boost your income and total returns from stocks or ETFs you already own. With this technique, you sell someone the right to buy your shares at a specific price (strike price) by a certain date (expiration date), in exchange for a premium payment. This premium can be 2-3 times higher than the dividends you receive from the stock, and you still get to keep the dividends and capital appreciation.
In this article, we’ll break down the concept of covered calls, how they work, and when they’re the right tool for you. We’ll also provide examples to help you understand the process.
Apply Life Time Free Credit Card Here
What are Covered Calls?
A covered call involves selling a call option on a stock you own. By doing this, you receive payment for decreasing your flexibility, as the buyer acquires the right (but not the obligation) to buy 100 shares of the company from you at the strike price before the expiration date.
Selling covered calls can provide high income even in flat or bearish markets. However, it also has the drawback of capping your upside as you may be obligated to sell your stock if it becomes too highly valued.
When to Sell Covered Calls?
It’s important to note that there are no one-size-fits-all solutions when it comes to investing, and selling covered calls is no exception. Buy-and-hold investors may be willing to hold onto their stocks for years, even if they become overvalued, while others might prefer to sell covered calls as a one-tactic strategy. The latter approach is usually gimmicky and doesn’t work equally well in all market conditions.
For example, it’s not ideal to sell covered calls when the market is very undervalued.
The best time to sell covered calls is when you have already calculated the price at which your shares would become overvalued. Instead of waiting for this to happen and then deciding whether or not to sell, you can plan in advance. You can determine the fair value of the businesses you own, and sell covered calls at strike prices that are significantly higher than that value. This way, you generate extra income from the stocks while holding them, and then sell them when they become significantly overvalued. You can then reallocate that capital to undervalued investments.
In conclusion, covered calls can be a useful tool for smart investors, but it’s essential to understand when they’re the right choice for your situation. By following this step-by-step guide with examples, you can learn how to make the most of covered calls and boost your returns.
Call-Selling Example
Reliance Industries (Lot size 250)
Current Price: 2323
Sell Call Strike Price: 2400
Imagine you own 250 shares of Reliance Industries, which is currently trading at a price of 2323. You are a conservative investor who is looking to generate some extra income from your holdings. In this scenario, you can sell a covered call option with a strike price of 2400. This means you are giving the buyer of the call option the right, but not the obligation, to buy your 250 shares of Reliance Industries at 2400 before the expiration date of the option.
In return for selling the call option, you receive a premium from the buyer, which is the amount paid for the option. The premium received can be 2-3x as high as dividends received from the stock, and can be a good source of extra income for you as the stockholder.
Now, let's consider a few scenarios:
If the stock price of Reliance Industries stays below 2400:
In this case, the call option you sold will expire worthless and you will keep the premium you received as extra income. Additionally, you still get to keep your shares and receive dividends from the stock.
If the stock price of Reliance Industries rises above 2400:
In this case, the buyer of the call option will exercise their right to buy your shares at 2400. You will be obligated to sell your shares at 2400, even if the current market price is higher. However, you will still receive the premium you received when you sold the call option, which can offset some of the opportunity cost of not being able to sell your shares at a higher price.
In conclusion, selling covered calls on Reliance Industries can be a good way to generate extra income from your holdings, while still allowing you to participate in some of the capital appreciation and dividends from the stock. However, it's important to keep in mind that selling covered calls also caps your upside potential, so it's important to carefully consider your investment goals and market conditions before making a decision.
Further Reading:
Generate Passive Income for Financial Freedom: A Guide to Making Money While You Sleep
No comments:
Post a Comment