How to Use Covered Calls to Potentially Lower the Price You Paid for a Stock
Have you ever wished you could lower the price you paid for a stock long after a transaction took place – I mean, without simply adding to the position at better prices to lower your average entry point?
This question is for everyone, but really, I aim this at the newer options traders and investors. If an investor learns to trade both stocks and stock options, he or she can use the two together to potentially lower a stock position's average price ("net cost basis") after the fact.
For those who don't know what an options contract is, each contract represents the right to buy or sell 100 shares of an underlying stock at an agreed-to price ("strike price") by a given expiration date.
A “put option” gives the holder the right to sell a stock to someone else at the agreed-to price regardless of what the shares are trading at in the market.
A “call option” gives the holder the right to buy the underlying stock at the strike price regardless of whether the stock is trading for more money on the open market.
The person who sells a call option might have to sell the underlying stock, known as having their shares“called away.”Conversely, the person who sells a put option might have to buy the underlying stock, known as having the shares “put”to him or her. You can buy or sell put or call options independent of owning the underlying stocks that they cover. In fact, puts and calls have their own prices that are set by investors who trade them on the options market similar to the way that other investors trade equities on the stock market.
How Can Covered Calls Potentially Reduce My Net Basis?
As a hypothetical example, let's say you own 100 shares of Stock XYZ, for which you paid $50 a share. In that case, your “net basis” for your investment (i.e., the price you paid for a stock) is $50 a share.
Because you already own 100 shares of Stock XYZ, you could reduce this net basis by selling one 100-share call option against your shares without taking on what's known as“naked" risk. (That's where you sell a call on a stock you don't already own.)
We'll get into the risks as well as the potential benefits of selling naked options down the road, but for now, that's a little complex. For a newer investor, it's probably best to start at the beginning -- and the very beginning of learning to trade options is learning how to write what are known as “covered calls.”
First Things First
The first thing you need to do to write a covered call is to know at what price you're willing to sell your shares and during which time frame. In my opinion, you should have both a target upside sales price and a “panic" downside sales price for any stock that you own. How are you supposed to be successful in investing if you don't know where you want to go and where you aren't willing to go?
For the purposes of our example, let's say that for the 100 shares of XYZ that you bought at $50 a share your upside target price is $55, which would produce a 10% gain. However, let's also say that the stock has gone the wrong way since you bought it and has been trading around $48. Now you'll need XYZ to gain almost 15% from here in order to hit $55 and give you a 10% gain. This is where a need to reduce your net basis through covered calls might arise.
If you scan XYZ's options pricing chain (a list of current prices on all of the different options available on a given stock), consider looking for a call contract that pays enough to help reduce your net basis. Let's say you decide to go out two months on expiration and sell a $53 call for $1.25. In our example, you sold your call on Feb. 7 and it expires on April 19.
Two things will happen:
1) You'll get a $1.25 per share“premium' paid right away into your account -- $125 for your 100-share call option.
2) Your account will now have two positions – you'll be “long” 100 shares of XYZ at $50.00 and “short" one April 19 XYZ $53 call at $1.25.
What Happens Next?
There are three possible outcomes for your April 19 $53 XYZ call:
1) XYZ's Price Languishes. Let's say the stock remains below $53 a share through the call contract's April 19 expiration date. In that case, the call dies a peaceful death and you get to keep your $125. In essence, your net basis on your XYZ shares dropped to $48.75 a share – the $50 a share that you originally you paid for the stock minus the $1.25 per share that you got from your call.
2) The Stock Hits $53 a Share by April 19. In that case, your 100 shares will likely be“called away" – purchased for $53 by the person you sold a call to. You'll get $53 per share, plus keep the $1.25 per share that you got writing a call option. You'll have effectively paid $48.75 per share for your stock ($50 purchase price minus the $1.25 per share for the call), so you'll have made an 8.7% gain, not counting any possible fees.
3) The Stock Goes Higher Than $53 – Say to $60 – by April 19. Your stock will be called away for $53 and you'll get the 8.7% gain illustrated above, but you'll miss out on the $7 a share of gains between $53 and $60. That's tough luck for you, but you got the help you needed when you wanted to lower your cost basis, but that comes with capping much of the stock's upside potential.
More Things to Know About Covered Calls
1) Many investors who hold a stock position over the long-term attempt to receive a steady revenue stream by writing covered calls every month or every quarter against the same shares, which are often never called away with proper position management.
2) Many traders try to maximize premium payouts by lining up their covered calls' expiration dates with known news events such as a company's earnings release. Other common events that people take into account include monthly or quarterly pension-fund or index rebalancings, "triple-witching" expirations or even things like local or national elections that could impact government policies.
3) For a call to pay a significant premium, there usually has to be a realistic chance that your shares will actually be called away. Covered calls have some risks involved for the people who sell them, although the premium paid by the buyer reduces the net basis for the seller, who is already long on the underlying stock.
Of course, there remains a risk that the stock will go down, but that risk is somewhat offset because writing covered call lowers your net basis. However, keep in mind the premium received is likely only a small portion of the total paid on the long stock. So, any downside protection can be very limited. There's also a risk that the underlying stock will rise above the strike price. In that case, you'll only get the strike price when the call buyer purchases your stock, plus any premiums received. You'll miss out on any upside over and above the strike price.
Options trading entails significant risk and is not appropriate for all customers. It is important that investors read Characteristics and Risks of Standardized Options before engaging in any options trading strategies. Options transactions are often complex and may involve the potential of losing the entire investment in a relatively short period of time. Certain complex options strategies carry additional risk, including the potential for losses that may exceed the original investment amount. Supporting documentation for any claims, if applicable, will be furnished upon request. Moomoo does not guarantee favorable investment outcomes. The past performance of a security or financial product does not guarantee future results or returns. Customers should consider their investment objectives and risks carefully before investing in options. Because of the importance of tax considerations to all options transactions, the customer considering options should consult their tax advisor as to how taxes affect the outcome of each options strategy. This article is for educational use only and is not a recommendation of any particular investment strategy. Content is general in nature, strictly for educational purposes, and may not be appropriate for all investors. It is provided without respect to individual investors' financial sophistication, financial situation, investment objectives, investing time horizon, or risk tolerance. You should consider the appropriateness of this information having regard to your relevant personal circumstances before making any investment decisions. All investing involves risks.
Disclaimer: Community is offered by Moomoo Technologies Inc. and is for educational purposes only.
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NYSE floor trader for over 30 years. Day trader, long-term investor, and anything in between.
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SPACELIGHT : No. Never gave it a thought
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多買多賺買少少虧金牛 : Good strategy
SGrobin : Cover call
Markio1315 : now my question is for those who hold 100 or more of $NVIDIA (NVDA.US)$ , would they want their covered calls to be assigned???
CᖇYᑌI᙭ : @104025852
i short the sheriff : options trading is both rewarding and dangerous if you don't understand the mechanics of it. Try paper trade first, maybe for months to get the hang of it.
Joe P : I tried to sell a covered call and wound up selling 100 shares for market price. That could have been a disaster. I wish I could find instructions on how to enter an options trade into Moomoo instead of only finding options trading theory.
Invest with SargeOP SPACELIGHT: LOL
Invest with SargeOP Markio1315: Tough one
stephen mullins : I haven't learned or traded in this stuff yet so I have a lot to learn
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