Learning a bit about options. Can anyone explain to me why this is a bad idea or wouldn't work?
Assuming example stock XYX with current price of $5.10, with calls selling for $.50 at a strike price of $5.
Buying stock to cover would be $510. Call premium would be $50. Call being exercised would be selling the stock for $500, losing $10 from the original purchase. Offset by the premium, this would leave a $40 profit.
I am sure I am missing something here. Thanks!
Call being exercised would be selling the stock for $500
This only happens if the stock ends up above the strike.
If the stock instead drops to $4, then your call expires worthless but your stock has a paper loss of $110. On the other hand, your profit is limited to the premium you get, so if the stock jumps to $6, your profit would be only $50.
Selling a covered call is essentially selling a put. You profit if the stock closes above (or slightly below) the strike price. The "break-even" point is the price you pay for the stock less the premium received - it this case, you profit if the stock is above $4.60 at expiration, whereas if you just own the stock, your break-even is $5.10. With a covered call, you give up profit potential in exchange for a lower break-even point.
I do this and while you won't get rich, as long as the company is fairly stable it's one of the safest ways to invest. I would look at something with a call option greater than .50 because the commissions will take some away and it will be short term gain for taxes.
It's not a bad idea per se. But it may not be the best idea.
A covered call has an asymmetrical risk/reward ratio. You receive a small premium while limiting the upside and retaining all of the downside risk. In addition, you can end up with a portfolio by adverse selection (your quality stocks are taken away without your participation in the big up moves and you'll end up holding the dogs that drop).
Now if you're willing to accept and ignore the risk of owning the stock (buy and hold up to a price) then selling a covered call at a higher target sale price would be feasible. It doesn't change the poor R/R ratio. It just facilitates some income while doing B&H.
There are some age old market expressions about selling covered calls:the expression is:
Sometimes you collect pennies in front of a steamroller
Most of the time you eat like a bird and sometimes you sh*t like an elephant
AFAIC, if you want to chase income, if possible (implied volatility and B/A width considerations), sell vertical spreads so that you have built in catastrophe protection.
