Covered Calls vs. Buy And Hold Strategy

Writing covered calls versus a buy and hold strategy can offer investors a lower risk alte ative than by simply holding on to stocks in a portfolio and waiting for them to go up in price. This is because, in exchange for putting a cap on the stock's upside, the investor receives some income and downside protection, while allowing them to make money whether the stock goes up, stays flat, or even if it goes down a little. Another advantage to writing covered calls is that it allows you to receive an income from equities that you already hold in your portfolio. This technique can also help you to lock in gains on these particular stocks. Let's use a covered call versus buy and hold example. In this example, an investor owns 100 shares of ABC Company stock that they purchased for $76 per share. Without taking into account commissions, the investor paid $7,600 for these shares of ABC Company stock. The investor decides to write one ABC Company call option with a strike price of $80, and with an expiration date that is a few months away. For writing (or selling) this call, the investor is paid a premium of $2 per share and receives $200 today. By implementing this strategy, the investor has now lowered his cost basis for the stock. And, if the price of ABC Company shares remains below $80, the investor will not be called upon to sell the 100 shares. In this case, the option will expire worthless and the investor keeps the $200 option premium. As long as the price of ABC Company shares stays below $80, the investor can write another call on the same shares when the first option expires. For as long as this goes on, the investor can continue to receive income in the form of option premium dollars. And, this premium serves to lower the investor's risk over simply just buying and holding the stock. In addition, as long as the investor continues to own the underlying shares, he will continue to receive stock dividends if any are offered on that particular stock. If, however, the price of ABC Company stock goes up during this time, the investor will be obligated to sell his shares for the agreed upon strike price. Let's say that the stock price goes up to $85 and the investor in the prior example must sell the shares at $80. In this scenario, even though the investor gave up some upside potential by not just buying-and-holding the stock, he still locked in a gain of $4 per share, plus the additional $200 received from the option premium. And, the option premium amount that the investor received served as a nice insurance policy just in case the stock shares had gone down instead of up. Selling covered calls is a trade-off between current income and lower volatility vs. reduced upside (putting a cap on what you can make). Not a great idea if you expect the stock to double, but a pretty good idea for large cap dividends stocks that are pretty slow to move.