Options have a reputation for riskiness, but some option strategies involve only limited risk. One such strategy is to sell covered call options against stock you already own. You can control the price at which you sell the call option by placing a limit order with your broker.
A call option lets you buy 100 shares of the underlying stock for a set price, the strike price, on or before an expiration date. You score a profit if the price of the stock increases, because this causes the call option to increase in value as well. You can instead become a call seller and collect the price of the call, called the premium. As the call seller, you agree to fork over the underlying shares if the buyer exercises the option. The premium you grab contains "intrinsic value" if the stock price is higher than the strike price. It also has "time value," based on the buyer's hope that the call's price will climb before it expires. The time value plummets to zero on the expiration date.
The call seller is on the hook to deliver the underlying shares whenever the share price rises above the strike price. This could be a risky situation for the seller if the shares suddenly skyrocket. The seller would have to buy costly shares and only receive the strike value of the shares from the call buyer. To guard against this unpleasant possibility, the seller can pre-purchase the shares before selling the call -- this is known as a covered call. The seller would normally sell a call with a strike price higher than the underlying shares' purchase price, ensuring a profit on the shares if a call is exercised.
As a call seller, you naturally want to collect the highest premium possible when selling covered calls. If you want a price higher than that currently available, you can enter a limit order, which sets the minimum price you’ll accept. If you use an online brokerage account, the order entry page will give you the choice of putting in an open order -- one that executes at the current price -- or a limit order. If you want a limit order, you enter the lowest acceptable price and any deadlines. For example, you could mark the trade as only good for the day or good until executed. If you buy and sell securities over the phone, tell your broker your limit price and deadline.
Net Debit Limit Order
You can also sell a covered call through a “buy-write” limit order. This is a combination order in which you buy the underlying shares and sell the call at the same time. The limit you set is the “net debit” -- the total amount you're willing to shell out on the transaction. For instance, suppose the shares are selling for $28.50 each and a call with a $30 strike price is selling for $1 per share, or $100. An open order would cost $2,850 minus $100, or a $2,750 net debit. If you instead set a limit of $2,700, your share purchase and call sale will only take place if the net debit is no higher than $2,700. This strategy is useful if you don’t want to scarf up the shares unless you can unload the call at your required price. Option brokers normally have online screens that accept buy-write limit orders.
Based in Greenville SC, Eric Bank has been writing business-related articles since 1985. He holds an M.B.A. from New York University and an M.S. in finance from DePaul University. You can see samples of his work at ericbank.com.