Let's imagine that you would like to purchase 100 shares of Disney (DIS) stock with the stock at $24.40. Pleased with the overall growth rate, you would like to hold the stock rather than sell it. Rather than just sitting back and collecting the Disney dividends, you can use options to generate additional income at minimal risk to you. You can do all of this in one transaction using our Covered Call screen.
With the stock at $24.40 you could sell one 27.5 call in the near month at $0.90. As each call is valid for 100 shares you are only able to sell one call.
|DIS trading @ $24.40|
|Buy 100 DIS @ $24.40||$2,440.00|
|Sell 1 OCT 27.5 Call @ $0.90||($90.00)|
|Cost of Trade||$2,350.00|
Knowing the stock price hasn't fluctuated much, you might have confidence that it isn't going to move higher than $27.50 in the short term. After all, that would be a more than 10% move. At expiration, if the stock is still below $27.50, you keep the $90 you received by selling the calls and the 100 shares of stock. At that point, you might decide to write another call for a future month.
Should the stock rise unexpectedly above $27.50, you will have two choices. You can either buy the calls back and keep the stock. Or, you can let the stock be called away and sell your 100 shares (1 contract x 100 shares) at the strike price of $27.50. The good news, in this case, is that you participated in the rise from $24.40 to $27.50 on the 100 shares you sold at 27.5. In doing so, you locked in an additional $310 in profit. The bad news is that you may have capital gains tax issues to deal with-especially if you've owned the stock for a long time and your cost basis is low.
Using Near Month Options
When writing covered calls, most investors tend to sell near month options for two reasons. First, the earlier the expiration, the less opportunity the stock has to trade through the strike price. Second, and equally important, is the role time decay plays in the value of the options. Like all out-of-the-money options, the call in the example above has no intrinsic value. As such, the only value is the time premium or time value which, in the final month before expiration, decays more and more rapidly. For these reasons, investors often sell options that have one month remaining until expiration.