Everything You Always Wanted To Know About Covered Calls

Most people who are invested in the stock market do not know that they can generate cash flow from their positions. The idea was first introduced to me back in 1998 by a fellow trader. The strategy is called covered call writing. Covered call writing is considered so safe that even brokerage firms that manage IRA accounts allow you to write covered calls.

Covered call writing is very simple to understand. It basically says that I’ll give you $5,000 now, if you allow me to buy your stock 3 months from now at a certain price. If I choose not to exercise this option, you keep the money and we part.

Now I will go into more detail. Do not worry, just keep re-reading this until you get it. I buy 1,000 shares of FGH at $10 and the stock goes to $11 several weeks later. I can make money right now without selling my stock by selling the option to someone to buy the stock from me six months from now at $12.50. For that option, the buyer has agreed to give me $0.50 per share or $500 right now.

The $500 is immediately deposited into my brokerage account, but an option position also shows up on my statement. I can not sell the stock prior to 6 months unless I buy back the option in the open market. The option price can fluctuate from day to day, therefore, I typically hold my stocks until expiration.

Six months from now, two things can happen. One, the stock goes above $12.50 and the person “calls” me out of the position, which I am more than happy to do since I bought it at ten. Second, the stock has declined below $12.50 and the option holder is holding on to a worthless option. The option holder would not “call” the stock from me at $12.5 when he or she might be able to buy it in the open market at $11.50.

I then start the process all over again and write the calls again.

So let me back up. What exactly did I do here? First, I hedged my position by 5% or $500. Second, I set a strict target price that I was willing to let the shares go for, $12.50. Finally, I created immediate cash flow that I could use for my daughter’s birthday or reinvest.

I can not tell you how happy this strategy has made me since the crash of 2000-2001. The strategy has helped me keep my head above water in this depressing market.

There are a variety of software programs available that will let you spot the best stocks to buy, then write covered calls against. Of course you do not need any software. The software just saves you some research time.

As a reminder, make sure you “know what you own” and consult with a tax professional or adviser before investing your hard earned money!

Do not buy any stock trading education materials until you see Lance Jepsen’s free stock market blog at how to invest in stock market, and learning the stock market