What is a covered options writer?

You might hear fancy words like “covered call” or “buy-write” thrown around by the finance folks. But really, a covered options writer is just someone who sells options contracts and actually owns the thing they’d have to hand over if the buyer wanted to use their option. It’s kinda like selling someone the right to buy your comic book collection, but you actually have the comics. Not just an empty cardboard box in your closet.

Two main types

There’s two big types of these “covered” options writers:

The call option crew

Let’s say you own 100 shares of some stock, like CoolTech Inc. You could sell Joe Shmoe the right to buy your 100 shares for $50 each anytime in the next month. That’s a “covered call.” You get paid a little something called a premium for giving Joe that right. If CoolTech stays under $50, great, you keep your shares and the premium. If it rockets above $50, well, Joe might take your shares but at least you got the premium.

The put posse

Now, if you were selling a “put” instead, it goes the other way. You’re giving someone the right to sell you something at a set price. Like saying “Hey, if you get sick of those Pokemon cards, I’ll take ’em off your hands for $100.” As long as you’ve got that $100 ready to go, you’re “covered.” Though you might end up with a binder full of Charizards you didn’t really want.

Why do it?

These covered writers aren’t daredevils. They’re usually trying to make some side cash without taking on a ton of risk. If you already own the stock or have the money set aside, your butt is pretty well covered. It’s not like those “naked” options writers betting the farm on where a stock will go.

The ups and downs

Slow and steady can win the race

The covered call crowd usually does it because they think the stock will just kinda chug along – not zoom to the moon or crash into the dirt. They’re happy to possibly sell their shares for a bit more than the current price and pocket that premium in the meantime.

The put posse usually thinks the stock will stay steady or go up. They’re okay potentially buying shares for a bit less than the current price. Especially since they’re getting that upfront premium too.

But you can miss out on the big moves

Of course, the catch is if CoolTech drops the new iGizmo and the price triples overnight, that covered call writer just watched a bunch of gains whoosh by. They’re stuck handing over the shares for chump change (comparatively).

Same deal if you wrote puts on OldTech Inc. and they declare bankruptcy out of nowhere. You’re now the proud owner of a bunch of worthless shares you paid way too much for.

More of a tortoise approach, not a hare

This is why covered options writing is more of a slow, steady income deal than a “get rich quick” scheme. You’re not likely to blow up your account, but you’re also clipping your shot at the really big scores. It’s all about consistently collecting those premiums.

The nitty gritty

Picking your targets

If you’re selling covered calls, you probably want to pick underlying stocks you wouldn’t mind parting with if the price jumped. Or at least stocks you think will be more sluggish than a hippo in quicksand.

For cash covered puts, you likely want to choose stocks you wouldn’t mind actually owning for the long haul if put to you. Ones with businesses so simple your grandpa could understand ’em.

Strike prices and time frames

When you write the options, you gotta pick the price the buyer could do the deal at (strike price). And how long they have that right (expiration).

If you don’t really want your shares called away, you pick a higher strike price – but the further “out of the money”, usually the smaller the premium. Shorter time frames (a month out instead of a year) also tend to mean smaller premiums.

It’s all a balancing act between how much premium you can bag and how likely it is you’ll actually have to do the transaction.

Taxes and such

Of course, Uncle Sam wants his cut. With covered calls, if your shares get called away, that’s basically like selling stock so you might owe capital gains tax. But the premium is taxed like normal income.

Cash covered puts can get tricky too – if they get put to you, there’s funky rules about the cost basis of your new shares. Might want to ring up the accountant.

The psychology of it all

FOMO is real

Probably the biggest mental game with covered writing is FOMO – fear of missing out. If some stock you wrote calls on suddenly blasts to the stratosphere, it can feel like you just worked a shift at the lemonade stand while your pals got hired at Google.

You gotta be real zen about it. “Easy come, easy go” and all that jazz. Remember, you’re playing the long, sustainable game. No room for woulda coulda shoulda.

It’s still real money

On the flip side, even though you’re usually dealing with 100 share blocks, it’s still real dough on the line. If you wrote some puts and wake up to a bunch of shares worth way less than you paid, that’s gonna sting like lemon juice on a paper cut.

Gotta size your positions so they don’t blow up your whole shebang if things go sideways. Slow and steady, like a sloth at the DMV.

Recap it and wrap it

When you boil it all down, covered options writing is all about generating extra income on stocks you already own (covered calls) or might want to own anyways (cash covered puts). You give someone else the right to buy your shares or sell you their shares at a certain price for a certain time. You pocket the upfront premium and cross your fingers the actual transaction never happens.

It’s a way to squeeze more returns out of your portfolio without going hog wild on risk. You’re never gonna hit a 10-bagger with this approach alone, but you probably won’t go bust either. It’s more like the index fund of options strategies. Not the sexiest thing, but it’ll probably get the job done over time.

Of course, there’s still risk you’ll miss out on big upswings or get caught holding the bag on some nosedives. And then there’s all the tax and cost basis record keeping just to spice things up.

But if you keep your position sizes in check and stay in your Zen garden mentally, covered writing can be a nice little boost to your portfolio returns. It’s the kind of strategy your grandpa would probably approve of. Though you might have to explain it real slow using lots of sock puppet examples.