Every financial investor will give you his or her advice about what strategies work best or worst with any given financial instrument. It’s hard to get through all of the noise, but with diligent research and thoughtful investing strategies, it is possible. While there is nothing wrong with simply ‘riding the market’ and investing in market indexes through a service like Betterment.com or something similar, some people want to get their hands wet in their portfolios and really manage what is happening. One financial derivative that could be part of your portfolio is the covered call, which is where you sell an option to buy an underlying investment which you already own at a particular strike price before a certain date in the future.
How it is supposed to work
When you sell the covered call option, one of several alternatives will occur. Regardless of what happens, you gain income on the sale of the option, and if the option is not exercised, you keep the income and the underlying investment and can do it again. If the option is exercised, the worst that can happen is that you missed out on potential increases in the stock value beyond the value of the option itself. If it is not exercised, you face the same risks owning that stock that you would have faced before, that is, that the underlying investment will lose its value. It is not a ‘low risk’ strategy. Compared to other financial options, it tends to have lower risk because of it’s covered nature; that is, because you already own the underlying stock, and won’t be forced to purchase an unexpectedly expensive stock on the open market.
Strategies that can work
Diverse portfolios of different kinds of investments and investment vehicles over time provide the highest returns in comparison with risk. Using covered calls as part of a diverse portfolio of investments can increase the annual income you extract from your investment portfolio, but not without risk. The best time to sell a covered call is when you believe the value of the stock will remain relatively constant throughout the duration of the call period. Optionally, if you believe the stock will decrease in value and as part of a different investment strategy you do not want to sell it outright, you could potentially put a covered call on that investment as well.
However, the success of these strategies requires that someone out there believes the stock value will increase, and therefore be willing to pay a premium on the ability to purchase the stock at a lower price at a future date. This is why it is not so clear cut – many proponents will have you believe that it is just that simple, but unless you know exactly what the market will do, and that it is opposite of what the market believes it will do, then you are effectively making guesses as to whether you will get income off of the strategy.
Strategies that don’t work
The least effective strategy for any financial investment goals is believing you will get rich quickly, and certainly that you will do so with minimal risk. High returns simply do not follow low risk. The old adage rings true: If it is too good to be true, it is. Additionally, placing all of your invested assets under covered calls is also a poor strategy. If you have extra investments (not essential to maintain your current standard of living or retirement), then placing them under covered calls may be a way to extract income from them while they are otherwise just sitting their. But taking all of your investments and betting them in this way is not a very good strategy – diversity is key.
In the end, well-managed covered calls can be an effective way of extracting income on investments you already own, but as any financial derivative, it does not come entirely without risk. It is not an effective ‘get rich quick’ scheme or the markets would already be using it as a common financial tool. Compound Stock Earnings is one of several online resources you can use to begin your research. Be smart with your finances, diversify your portfolio, and stick with investment decisions that make sense to you.
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- The Covered Call Strategy | My Covered Call Strategy | July 20, 2013