When an investor’s primary goal is to profit over the long term from stock ownership (stock investing), and calls are written against the portfolio stocks to generate income from them, covered call writing is an ancillary strategy.
When a trader regularly purchases stocks with the intention of writing calls on them, covered call writing—also referred to as the total return approach—is the main tactic. Let us revisit our two main strategies”.
What is a Buy-Write Order?
A buy-write order is a popular options trading strategy that involves buying a stock and simultaneously selling a call option on that same stock. This strategy allows investors to generate income from the premium received for selling the call option, while also limiting their potential upside gains on the stock.
Understanding the Covered Call Strategy:
- Mechanics:
- Purchase a stock with available options.
- Sell (write) a call option on that stock with the same expiration date as the desired holding period.
- The call option gives the buyer the right, but not the obligation, to buy the stock from you at the strike price on or before the expiration date.
- Benefits:
- Generate income from the premium received for selling the call option.
- Provide a small hedge against potential downside risk in the stock.
- Offer a defined exit point at the strike price, potentially locking in profits.
- Drawbacks:
- Limit potential upside gains if the stock price rises above the strike price.
- Risk of early assignment if the stock price rises significantly, forcing you to sell the stock at the strike price even if you would prefer to hold it.
Key Considerations for Covered Calls:
- Strike Price:
- Choosing a higher strike price reduces the premium received but provides more upside potential.
- Choosing a lower strike price increases the premium received but limits upside potential and increases the risk of early assignment.
- Expiration Date:
- Selecting a shorter expiration date results in higher premiums but reduces the time you have to benefit from potential stock price increases.
- Choosing a longer expiration date reduces the premium received but gives you more time to profit from potential stock price increases.
- Underlying Stock:
- Consider stocks with moderate volatility and a history of paying dividends to maximize premium income and downside protection.
- Avoid highly volatile stocks or stocks with low dividend yields, as these may not be suitable for covered calls.
Profit and Loss Potential:
- Maximum Gain:
- Limited to the premium received plus any stock price appreciation up to the strike price.
- Occurs if the stock price remains below the strike price at expiration or if the call option expires worthless.
- Maximum Loss:
- Limited to the difference between the purchase price of the stock and the strike price minus the premium received.
- Occurs if the stock price falls to zero or if the call option is exercised and the stock is assigned at a lower price than you paid for it.
- Break-Even Point:
- Calculated as the purchase price of the stock minus the premium received.
- Represents the stock price at which you will neither profit nor lose from the covered call strategy.
Suitability of Covered Calls:
- Covered calls are suitable for:
- Income-oriented investors seeking additional income from their stock portfolio.
- Investors with a neutral to slightly bullish outlook on the underlying stock.
- Investors who are comfortable with the possibility of early assignment and limited upside potential.
- Covered calls may not be suitable for:
- Investors with a strongly bullish outlook on the underlying stock.
- Investors who are unwilling to sell their stock at the strike price.
- Investors who are uncomfortable with the risks associated with options trading.
Optimizing Your Covered Call Strategy:
- Monitor market conditions:
- Adjust your strike price and expiration date based on market volatility and your outlook for the underlying stock.
- Consider rolling your options:
- If the stock price rises and you want to continue holding it, you can roll your call option to a later expiration date for a new premium.
- Be prepared for early assignment:
- Have a plan in place to replace the stock if it is assigned early.
The covered call strategy can be a valuable tool for generating income and managing risk in your investment portfolio. By understanding the mechanics, benefits, and drawbacks of this strategy, you can make informed decisions about whether it is right for you and how to implement it effectively. Remember to carefully consider your investment goals, risk tolerance, and market outlook before employing covered calls.
Portfolio Writes and Buy-Writes
Writing calls to generate income on investment portfolio stocks is what this practice entails. Most buy-and-hold investors don’t write calls on their stocks. It’s unfortunate because writing calls on them would significantly increase dividend and price appreciation returns (which are only considered a “return” if the stock is sold).
One popular way to boost portfolio returns is for traders to sell call options on stocks that are already in their holdings. Comparing portfolio writing to merely holding stocks for dividends and future appreciation yields several significant advantages:
- It produces a regular income from stocks.
- The return is a lot more than if you just kept the stocks.
- Overwriting reduces risk approximately one-third.
- Overwriting produces much higher returns in declining markets.
Chicago Board Options Exchange (CBOE), the organization that developed the CBOE S Above all, it transforms an inactive investment into one that generates income.
It has been observed that over the past ten years, the stock market has, on average, always increased by roughly 7% to 9% annually. But there have also been protracted bear markets or price stagnation. Even with a fundamentals-based approach, there is undoubtedly a timing component to stock investing.
Furthermore, many investors’ true time horizon is between 10 and 25 years, from the moment they have significant money to invest to the moment they start to run out of money for retirement. There have been numerous instances where the market underperformed for ten years or longer. It’s true that stocks purchased in 1929, just before the crash, did not return to their 1929 price until 1954—a mere 25 years later.
Nobody is arguing against stock investing; it is obvious that it can But it is not an automatic path to wealth. Conventional stock investing depends on both a growing market and consistent investments made over time. The value of a stock portfolio cannot increase unless the stocks increase in price or split and rise in value.
Many make poor stock selections, placing their money on a technology or market that eventually fades. Some people just enter the stock market at the wrong time and see their investments decline or stagnate.
By creating a portfolio, a stock owner can effectively receive a monthly special dividend on their shares—the call premium. This increases declared stock dividends and, for non-dividend stocks, generates income from the stocks that was not previously received. Even a return that averages only 1% per month would make a significant contribution to the total returns over time and surpass the average annual return. We explore portfolio writing in depth further on.
What is a buy write? A buy write is the process of selling call options in exchange for stock that was bought specifically for that purpose.
The writer’s main goal is to generate a return from the call write. Though many buy-writers trade to boost returns, their primary role is income investing; they are neither traders nor speculators.
Buy-writers are not “investors” in the same sense as buy-and-hold investors because they are in the business of making cash flow from their investments. In other words, covered writers profit from stocks on a regular basis rather than holding onto trades for an extended period of time in the hopes of capitalizing on price growth.
Almost always, when the covered call strategy is discussed, buy-writing is meant. The objective is income investing, which uses stocks as assets that generate income rather than long-term stock holding.
A buy-write is straightforward in and of itself because the investor wants to:
- Buy value stocks,
- Write calls on them, and
- sells the stock in order to increase the return or guarantee the return.
Selling call options produces income on the shares. As a result, the shares are basically an asset bought with the intention of making money. The only thing that can go wrong with a buy-write strategy is for the stock to retrace or, worse, sell off, leaving the trader with the option of either holding onto the stock in the hopes of a recovery or selling it at a loss.
Naturally, there are trade management techniques to handle declining stocks (discussed later on), but as of yet, no stock has been created that is incapable of experiencing a price decline.
The buy-writer’s plan is to purchase the stock, “cream” it for a premium, and then sell it for a profit that is reasonable. The goal is to produce a steady stream of revenue with few, manageable losses. Only if the trader practices discipline in the four primary areas of covered writing—discussed below—is this feasible.
The advantage of this approach is that, should the stock close below the designated strike, the trader will profit extra from selling the call options. The call premium protects against downside losses in the event that the stock price declines from its current level of value. The option premium provides additional revenue to the stock position if the stock stays the same or slightly rises.
This option strategy sells call options in opposition to a long stock position in an effort to generate additional revenue. The strategy is also referred to as a “covered call”. To get the premium from the options, a trader with a long stock position will sell call option contracts in an amount equal to that stock position.
Look at the example below, where we’ll assume that a trader has bought 100 shares of Apple [AAPL] at $112 in order to establish a long stock position. 50. The payout is displayed if the trader sells one call option contract for 100 shares at the strike of 114. Although there is still a risk to the downside and a cap on upside potential, this strategy is supported in the short term for modest movements by the additional money received from selling the options.
How to purchase and what is a covered call (buy write) with etrade (4min)
FAQ
How does a buy-write work?
Is buy-write the same as covered call?
Is it better to buy or write options?
What is the payoff of a buy-write strategy?
What does buy write mean?
What does Buy-Write mean? Buy-write is an options trading strategy where an investor buys an asset, usually a stock, and simultaneously writes (sells) a call option on that asset. The purpose is to generate income from option premiums.
What is an example of a buy-write strategy?
The most common example of this type of strategy is writing a covered call on a stock already owned by an investor. A buy-write is a relatively low-risk options position that involves owning the underlying security while writing options on it. A covered call is a common example of a buy-write strategy.
Should you buy or write stocks?
In other words, if your investment method is to buy stocks and hold them for a long period of time, the buy-write strategy will either add income to your portfolio, or reduce the loss if your investments are trending downward in price. However, if stock prices rise, you may have a lower, overall return.