If you’re a beginner investor who’s just starting out.
You might wanna check out our Ultimate Guide to Investing FIRST before you get into something slightly more cheem like options.
If you already know what you’re doing…
Here’s how you can get free money by holding stocks with a covered call options strategy.
TL;DR: How to Get Free Money by Holding Stocks With Covered Call
It’s a pretty simple investment strategy, really.
A covered call is where a call options seller agrees to sell his or her stocks to a buyer for a fixed price.
In return, the seller earns a premium.
So rather than just buying solid stocks with sound fundamentals and watching the stock price go up and down.
You can consider doing covered calls on the stocks you own to get some free money along the way.
What Is A Covered Call?
Before we get into the covered call options strategy, you need to understand what is a call option.
Basically, a call option allows you to buy a stock at a certain price.
Let’s say you wanna buy Apple stocks (NASDAQ: AAPL) at… $50.
Now, you’re probably asking yourself, “Who is siao enough to sell me Apple stocks at $50?!”
Just humour me.
If you purchase a call option that allows you to buy AAPL at $50…
Then effectively you have the right to buy AAPL at $50 from whoever is siao enough to want to sell it to you at that price.
Since SO many people are using moomoo right now, here’s a screenshot of the options (with an expiry date of 27 August 2021) available for AAPL off the desktop platform:
I know, I know.
So. Many. Numbers.
Just focus on the row that is highlighted.
What this tells me is if I want to buy AAPL at $130 (Strike), I would need to pay a premium of $17.10 (Bid) x 100 = $1,710 for the AAPL call option.
Now that we understand what a call option is.
A covered call is basically the reverse of a call option, where instead of buying the rights to buy AAPL stocks.
You’re selling the call option to an options buyer.
In doing so, you get paid a premium.
And in return, the options buyer now has the right to buy AAPL at a fixed price from you (aside: just don’t agree to sell it to them at $50)
Most importantly, you’ll first need to own 100 stocks of whatever stock you wish to dabble in, in order to do a covered call.
This way your call option is COVERED by your stocks.
(Geddit? That’s why it’s called a covered call.)
And if the options buyer decides to buy your stocks, you’ll have to sell your stocks to the buyer.
Let’s look at the options for AAPL again:
Assuming I already own at least 1 lot of AAPL shares, and I wanna sell a covered call on 1 lot of AAPL with a strike price of $130.
I would be paid a premium of: $17.11 x 100 = $1,711 (AKA FREE MONEY)
But wait, there’s more…
So… What Happens After I Sell A Covered Call?
Scenario 1: Stock Price Goes Below Option Strike Price
This is the BEST CASE SCENARIO.
The option will not be used because the options buyer would not be stupid enough to exercise the option.
In this case, the option will expire worthless.
You get to keep the premium that the options buyer paid you.
AND you get to keep your AAPL stock.
Scenario 2: Stock Price Goes Above Option Strike Price
The options buyer will most likely exercise the option.
You’ll still get to keep the premium the options buyer paid you.
BUT you’ll be forced to sell your AAPL stock at the agreed price.
How to Get Free Money by Holding Stocks With Covered Call?
The covered call options strategy capitalises on the premiums you collect as a source of additional income.
If you own a very stable stock that usually trades sideways, think Bank of America Corp (NYSE: BAC):
The price gain you earn in a year is about 35% if you held it from January 2019 to January 2020.
That’s pretty decent.
But let’s say you start doing a covered call with:
- a 30-day expiry
- delta of 0.30 (meaning a 70% chance of not being assigned) or lower
- and a $40 strike price
Current stock price: $37.98
Covered call premium: $0.42 (every 30 days)
1-month yield: $0.42 / $37.98 ≈ 1.1%
1-year total yield: 13.2%
That brings your total return to 35% + 13.2% = 48.2%
Of course, I’m IGNORING market fluctuations and the realities of the real world here where you never get assigned and never have to sell any of your BAC stocks.
Throughout that 1 year of covered calls, you’ll probably be assigned some calls and have to sell.
What Are The Disadvantages of The Covered Call Strategy?
1) You Need To Own The Stocks First
In order to get started with covered calls, you need to at least hold 1 lot (100 stocks) of a particular stock.
So if you’re going with AAPL: $146.77 x 100 = $14,677
Yes, you read that right.
You need a whopping $14k or almost S$20,000 to get started.
This means that it might be a better idea to go with stocks like BAC: $37.98 x 100 = $3,798 (S$5,164)
That’ll probably be a little more palatable.
2) Your Upside Is Limited
Let’s say you own 100 stocks of AAPL ($146.77) and you decided to do a covered call on it.
If you sold a covered call at a strike price of $180 and the price never even comes close to $150.
Then great, that’s FREE MONEY for you.
HOWEVER, if Apple suddenly starts selling their long-awaited electric car for the price of an iPhone and everybody decides that they need one…
Market sentiment is frothing at the teeth and AAPL’s stock price rockets up to $500 a piece…
You’ll be forced to sell your AAPL stocks at $180.
That’s why covered calls work best with stocks that don’t really move much.