| "Selling a covered call" is when you own the stock and then write/sell a call, using the stock you own as collateral. For example, TWTR is currently $73/share. Suppose you own 100 shares of TWTR. The March 2014 85 strike call has a bid of $7.90. Suppose you sell one 85 strike TWTR call for $7.90. (1 call equals 100 shares.) You immediately collect $790 in premium. Your cost basis in your TWTR shares is reduced by $7.90 per share. (for capital gains tax purposes) If TWTR is above $85/share in mid-March 2014, whoever owns that call option will exercise it. You sold your TWTR shares for $85/share, even if the actual price is much higher. You effectively sold it for $92.90 per share, because you also collected $7.90 when you wrote the call. If TWTR is below $85/share in mid-March 2014, the call option expires worthless, and you keep your TWTR shares and your $7.90. It's a covered call, you already own the shares, so your loss is limited if TWTR skyrockets. If TWTR goes to $200/share, you lose big on the call, but that is offset by the shares you own. Superficially, this seems like a good trade. You get $7.90 now, and if TWTR goes up, you sell at a price you're happy with. However, this is AN IDIOT TRADE. You might as well just write Goldman Sachs a check directly if you're going to do such stupid things. Why? In the Black-Scholes formula for pricing options, the "average gain" of stock equals the risk-free rate. However, on average, stocks go up MUCH MORE than the risk-free rate. When you write a covered call, you're giving up all the upside. On average, the stock goes up by more then the premium you get for writing the call, making this an idiot trade. The whole point of being in the stock market is that you make good picks and get a 100% or better gain. You give up that upside when you write the covered call. The premium you receive for writing the call does not offset (on average) the missed gains. When you write the covered call, you still have the risk that the bubble pops and TWTR crashes. But, you miss out on all the potential upside if there are many greater fools willing to buy it later. |