What is a Covered Option anyway?
You might’ve heard some fancy Wall Street types tossin’ around the term “covered option”. But what the heck does that even mean? Here’s the scoop in plain English that anyone can understand.
A covered option is when you sell an option contract, but you already own the thing the option represents. The “thing” is usually a stock or some cash. And by selling the option, you’re giving someone else the right to buy your stock or take your cash.
Why Would You Want to Do This?
The main reason to sell covered options is to make some extra dough without taking on too much risk. When you sell the option, you collect a chunk of change called the premium. This premium is yours to keep no matter what happens.
Think of it like renting out a room in your house. You already own the house, so renting the room is pretty low risk for you. And you get to pocket the rent money each month. Selling covered options works the same way – you already own the stock or have the cash, so you’re not really risking much by selling the option. And you get to keep the premium either way.
Covered Calls: Selling Options on Stock You Own
One popular type of covered option is the “covered call”. This is when you own at least 100 shares of a stock and you sell a call option on those shares.
What’s a Call Option?
A call option gives the buyer the right (but not the obligation) to purchase 100 shares of a specific stock at a set price (called the strike price) within a certain time period (called the expiration date).
So let’s say you own 100 shares of ABC stock. The current price is $50 per share. You could sell a call option with a strike price of $55 that expires in one month. This means the person who buys your call option has the right to buy your 100 ABC shares for $55 each, any time in the next month.
What Happens Next?
A few different things can happen after you sell that call option:
- ABC stock stays below $55. If the stock price never hits $55, the option will expire worthless. The buyer won’t exercise it because they could just buy the shares on the open market for less than $55. You keep your 100 shares and also keep the premium from selling the option. Nice!
- ABC stock goes above $55. If the stock price rises above the strike price, the buyer will likely exercise the option. They’ll pay you $55 per share and take your 100 shares. You still keep the premium, but you had to sell your shares for less than the current market price. Bummer!
The Tradeoffs with Covered Calls
The upside of selling covered calls is that you get paid the premium no matter what. But the downside is it limits your potential profit.
If the stock rockets to the moon, you’re locked in at selling for the strike price. So while everyone else is poppin’ champagne, you might be feeling some FOMO. But hey, you still made money – just not as much as you could have.
Covered Puts: Selling Options to Buy Stock
On the flip side of a covered call is a “covered put”. This is when you sell a put option and have enough cash set aside to buy the stock if the put buyer exercises the option.
What’s a Put Option?
A put option gives the buyer the right to SELL 100 shares of a stock at the strike price before expiration.
Let’s go back to our ABC stock example. This time, let’s say you have $5,000 in cash and you sell a put option with a $50 strike price expiring in one month. If the buyer exercises, you’re obligated to buy 100 shares of ABC for $50 each (which will cost you the $5,000).
What Can Happen With a Covered Put?
Just like covered calls, a couple scenarios can play out:
- ABC stays above $50. The put option will expire worthless and you pocket the premium. You still have your $5,000 in cash. Cha-ching!
- ABC falls below $50. The put buyer will likely exercise and force you to buy their 100 shares for $5,000. You’re still out the same $5,000, but you now own 100 shares of ABC. If you think ABC will bounce back, this could be a good thing. If not, well, you might be bagholding for a while.
The Pros and Cons of Covered Puts
Just like with covered calls, the big advantage of selling covered puts is pocketing the premium. You’re getting paid to possibly buy a stock you want to own anyway.
But there are risks too. If the stock craters, you’re on the hook to buy it at the strike price, which could be way above the current market price. You better really want to own those shares!
The Bottom Line on Covered Options
Selling covered options can be a smart way to generate extra income from stocks you already own (covered calls) or have cash ready to buy (covered puts).
Just remember the premiums you collect will always be a tradeoff. With covered calls, you cap your potential profit. And with covered puts, you might end up buying a stock for more than it’s currently worth.
But if you’re looking for a relatively low-risk way to squeeze more juice out of your portfolio or get paid to buy stocks you love, covered options are worth considering. Just make sure you understand the ins and outs before diving in!
Covered options – not as complicated as they sound, right? Now get out there and start cashin’ those premiums!
