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Futures & Options: Writing a Covered Call




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This article is from the Investing Articles: Stocks and Options series.

Futures & Options: Writing a Covered Call

Writing a covered call consists of the sale of a call while simultaneously owning the underlying security. The seller of the call (the writer) is usually negative or neutral on the direction of the underlying security. Although, it can also be viewed as a mildly bullish position. Should the underlying security rise in price, he will not participate fully in the rise. However, he has now protected himself should the security decline in price. If the underlying security remains relatively unchanged, he will profit if the call expires worthless.

An investor would want to write calls against the stock that he owns to increase income and decrease the volatility of his portfolio. Owning the stock outright, has the disadvantage of leaving the owner vulnerable to sideways moves and declines in price. In fact, the only time the call writer doesn't do well writing a covered call is if the underlying security rises in price by a substantial amount. The call writers position will outperform the other position if the underlying security rises in price slightly, stays the same, or declines in price. Because of the advantages of writing calls, many portfolio managers, institutions, and private investors, are writing more and more calls.

Most often, the writer of a call deposits the underlying securities with his brokerage firm. However, the call writer can also deposit the underlying securities with a bank. The bank will then issue an 'escrow receipt' or a 'letter of guarantee' to the brokerage firm where the investor does his options business. However, the bank charges for this and it can get expensive. An alternative is to deposit the underlying securities with a bank which is a member of the Depository Trust Corporation. The DTC guarantees the Option Clearing Corporation (OCC) that it will deliver the stock to the OCC should the option be assigned. Generally, there is no charge for this. However, only the largest banks are members of the DTC. For most individual investors, leaving the stock with the brokerage firm is the easiest and least expensive thing to do.

When you sell an option on your stock, you are performing a transaction known as writing a covered call.

By writing covered calls, you can lower your risk on your investment, you can greater predict how much money you will make, and you can dramatically increase your profits. Most importantly, selling other people the right to buy your stock gives you the ability to make consistent, compounding returns on your money.

 

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