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A way to earn
additional income on your
stock portfolio. For
conservative investors,
selling calls against a long
stock position can be an
excellent way to generate
income.
Example
Let's imagine that you would
like to purchase 100 shares
of Disney (DIS)
stock with the stock at
$24.40. Pleased with the
overall growth rate, you
would like to hold the stock
rather than sell it. Rather
than just sitting back and
collecting the Disney (DIS)
dividends, you can use
options to generate
additional income at minimal
risk to you. You can do all
of this in one transaction
with some brokerage
companies.
With the stock at $24.40 you
could sell one 27.5
call in the near
month at $0.90. As each call
is valid for 100 shares you
are only able to sell one
call.
|
DIS Trading at
$24.40 |
|
Buy |
100 DIS
@ $24.40 |
$2,440 |
|
Sell |
1 OCT 27.5
call @
$0.90 |
($90) |
|
Cost of Trade |
$2,350 |
Knowing the stock price
hasn't fluctuated much, you
might have confidence that
it isn't going to move
higher than $27.50 in the
short term. After all, that
would be a more than 10%
move. At expiration, if the
stock is still below $27.50,
you keep the $90 you
received by selling the
calls and the 100 shares of
stock. At that point, you
might decide to write
another call for a future
month. |
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Should the
stock rise unexpectedly above $27.50, you
will have two choices. You can either buy
the calls back and keep the stock. Or, you
can let the stock be called away and sell
your 100 shares (1 contract x 100 shares) at
the strike price of $27.50. The good news,
in this case, is that you participated in
the rise from $24.40 to $27.50 on the 100
shares you sold at 27.5. In doing so, you
locked in an additional $310 in profit. The
bad news is that you may have capital gains
tax issues to deal with-especially if you've
owned the stock for a long time and your
cost basis is low.
Using Near Month
Options
When writing
covered calls, most investors tend to sell
near month options for two reasons. First,
the earlier the expiration, the less
opportunity the stock has to trade through
the strike price. Second, and equally
important, is the role time decay plays in
the value of the options. Like all
out-of-the-money options, the call in the
example above has no intrinsic value. As
such, the only value is the time premium or
time value which, in the final month before
expiration, decays more and more rapidly.
For these reasons, investors often sell
options that have one month remaining until
expiration.
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