Introduction To Covered Call Writing
Being a member of an investment club is fun. You have an opportunity to expand your investing knowledge, gain experience managing investment dollars, and earn some money.
Traditionally, most successful investment clubs adopted a buy-and-hold investment philosophy and carefully chose stocks to buy. The objective was to earn money as those companies grew and prospered over the years. Some clubs were less disciplined and tried to profit by chasing hot' stocks. There are many ways to manage a club's investment portfolio and in today's world, sophisticated clubs are adopting modern investing methods.
The purpose of this, the inaugural Know Your Options column, is to describe how your club can adopt one of the more sophisticated yet simple to learn and use strategies. It's called covered call writing and is a conservative strategy using stock options. The strategy is very appropriate for investment clubs and is widely used by individual investors.
Brief Description Of Covered Call Writing In Layman's Terms:
Your club enters into a contract that is valid for a limited, but agreed upon, period of time. Your club sells the right to buy 100 shares of a specified stock at a mutually agreed upon price. The other party to the contract pays your club a cash premium. That cash is not a down payment, but is yours to keep no matter what else happens. Note: The other party is not obligated to buy your stock, but merely has the right to do so. You must sell your stock if and when the other party chooses to buy as long as you are notified before the contact expires.
There are 2 possible outcomes to this contract::
Note: Both outcomes are good for your club. If you don't sell the shares, you are ahead by the cash premium you received. If you do sell, the sale occurs at your price and you keep the cash premium as a bonus.
The contract described above is a call option. The buyer of a call option has the right to buy 100 shares of a specified stock at a specified price (called the strike price) for a specified period of time. The price the option buyer pays to the option seller is called the premium.
Let's assume you have enormous confidence in your club and it's membership, and your goal is to earn 20 percent per year on your investments. That's almost double the rate of return produced by the American stock market in the past - but you believe you can accomplish this goal nonetheless.
Let's look at one of your holdings, XYZ trading at $50 per share, and consider two different ways in which you can achieve your target profit. Then you decide which method gives you the better chance of achieving your goals.
Conclusions: When using covered call writing
What's the Cost of Adopting Covered Call Writing?
This strategy enhances profits and reduces losses most of the time. But you must give up the chance of earning a bonanza on your stock. No matter how high the stock rises, you are obligated to sell your shares at the strike price. Thus, if your goal is to own stocks that double again and again, covered call writing is not for you.
Thus, the question: Is your club much better at stock selection than everyone else? Can you consistently find the next great growth company, such as Microsoft or Wal-Mart? Do you want to attempt to find those companies? Do you prefer not to limit the selling price of your shares? Or, do you prefer to use a method that increases your chances of outperforming the market on a consistent basis? If your objective in joining an investment club is to learn how to become a successful investor, then you owe it to yourself to investigate covered call writing. It's not for everyone, but is it for you and your club?
Next time we'll take a detailed look at real world examples of Covered Call Writing.