For investors interested in getting started with options, a covered call can be an easy, relatively risk-free strategy.
In this segment from Motley Fool Live that first aired May 7, Motley Fool Canada analyst Jim Gillies and Fool.com editor/analyst Ellen Bowman discuss what a covered call is and why you would use one.
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Jim Gillies: The first strategy we can talk about is called a covered call.
Ellen Bowman: Yes.
Gillies: All that means is you have a 100 shares, because options or contracts in units of a 100 shares, you must own or go out and buy a 100 shares of the underlying. Then for each 100 shares you own or purchase, you then sell to the open or short a specific call option, again, the call option is the right to buy the underlying stock. So if I sell you, Ellen, the right to buy and you decide to exercise that right, what do I have to do?
Jim Gillies: If I've sold you the right to buy and you say, ”Jim, I am going to buy,” then guess what? Jim is going to sell.
Bowman: You'll have to.
Gillies: I don't have a choice. … Covered call, you own your stock, and you buy your stock. You sell the open call option against your shares. One call for every 100 shares you own or purchase. In the event the stock goes on a skyrocket, because you are short the call, you have the obligation to sell. You are going to sell those shares.
Bowman: The strength place that I pick if I say Apple (NASDAQ: AAPL) isn't going to make it above $145. I think I'm rounding up higher than you did for no analytical reasons whatsoever. [LAUGHTER] and I say by July and I sell those calls, so I get paid immediately. Somebody pays me to take on that risk. Stop me if I'm interrupting any place. Then Apple goes to $300 because Tim Cook clones themselves. The Zune is erased from history, and there's nothing but Apple everywhere we go. I still have to sell to those whoever bought those calls. I got to sell at 145 regardless of?
Gillies: Correct … But I think some people have really keyed in on the fact that covered calls can be expensive, but I also think there are very good starting point for options practitioners for another really good reason, at least I think it's a good reason. That is options, you've probably heard, you've probably been scared, not you because you've been hanging around with it.
Bowman: I was at first though.
Jim Gillies: Okay. But you're not anymore, but other people would be. Certainly if you've read things by Peter Lynch or other, they might scare you. Ninety percent of options expire worthless and you don't want that. If I sold that, I do. [LAUGHTER]
Bowman: Yeah. [LAUGHTER] Would I make the money? Because then I want.
Gillies: Yeah, so that's an incomplete viewpoint, frankly. But there are other options strategies. As you know, there are great, many other options strategies. One of the attractive points about options is their ability to leverage.
Bowman: Yeah. That's one of the scariest things and one of the coolest thing about them.
Gillies: Well, it's cool, if it's working in your favor.
Bowman: Exactly, and it's terrifying if not.
Gillies: There's nothing better than when options leverage works in your favor. You've got a bullish position leverage setup, stock goes to the moon, [LAUGHTER] guess who's eatin' the steak sampler this week.
Bowman: Hell yeah, I go to Cleveland.
Gillies: I'd go to Cleveland, the steak, for the steak. But if it's leveraged against you?
Ellen Bowman: You could find yourself. We would hear that sometimes from members on the service, you find yourself deeply indebted, deeply obligated to things that you didn't expect.
Gillies: Or to fix it, you'd be selling things you didn't want to sell. Can you imagine, I'll pick on him because I think he's still listening, if Jim Mueller, for example, had engaged in one of these horrific, because he never would, but engaged in one of these terrific leverage style transactions which went against him, and to make good, he had to sell his Netflix stock. Can you imagine?
Bowman: Yeah, of course, the cost bases of eight dollars or whatever.
Gillies: Yeah. Here's your big tax bill, Jim, and don't do that again. He would be brokenhearted. [LAUGHTER].
Bowman: Well, we can't end there.
Gillies: Here's the good news. With covered calls, it is quite literally impossible to blow yourselves up by leverage.
Bowman: This is true. This is another reason that we are recommending them for beginners such as myself, you can lose the shares, and ideally, you only wrote the calls on shares that you would be happy to let go up at that price.
Gillies: You need to repeat that Fools. You've got the live stream, go back 15 seconds and listen to what Ellen just said.
Bowman: Let me try to say it again, but eloquently. You should only write covered calls on a stock that you are willing to sell at the strike price, you'd be perfectly happy to see it go. If you love it too much and you would want to hang onto it, then don't write the calls because all you can lose is your shares, which is wonderful. But if you love your shares, you don't want to lose them so make sure you pick a company that's for all that. Jim and I disagree a little bit about Apple. For all of that, I loved this example, I might not write covered calls on Apple. I might move to something else in my portfolio that I have enough that I can use 100 shares of because I don't necessarily know that I would be willing to let go of it. That's part of one of the emotional things in options investing is that for your darlings you don't want to risk them.