If you're new to investing in the stock market, one strategy you might want to consider is the covered call strategy. This strategy can be a good way to generate income from your investments while limiting your downside risk.
In this article, we'll explore the covered call strategy with Amazon stock.
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What is a Covered Call?
A covered call is an options trading strategy in which an investor holds a long position in an asset, such as a stock, and sells call options on that same asset. The call options give the buyer the right, but not the obligation, to buy the asset at a specified price (the strike price) on or before a specific date (the expiration date).
When you sell a call option, you receive a premium (the price of the option), which you get to keep whether or not the option is exercised. If the option is exercised, you must sell the asset to the option buyer at the strike price. If the option is not exercised, you keep the premium and the asset.
The covered call strategy is called "covered" because the investor already owns the asset that they are selling the call options on, so they are "covered" if the option is exercised.
How to Implement a Covered Call Strategy with Amazon Stock
Let's say you own 100 shares of Amazon stock, currently trading at $100 per share. You believe that the stock price will stay relatively stable over the next month, but you also want to generate some income from your investment. Here's how you can implement a covered call strategy with Amazon stock:
Step 1: Choose a strike price and expiration date
You need to choose a strike price and expiration date for your call options. Let's say you choose a strike price of $110 and an expiration date of one month from now.
Step 2: Sell call options
You sell one call option contract (which represents 100 shares) with a strike price of $110 and an expiration date of one month from now. The current premium for this option is $2.3 per share or $ 230 total for the 100 shares. You receive this premium upfront.
Step 3: Wait and see what happens
Now you wait and see what happens. If the stock price stays below $110, the option will expire worthless, and you keep the $230 premium. If the stock price goes above $110, the option buyer will exercise their option, and you will be required to sell your 100 shares of Amazon stock to them for $110 per share. In this case, you still get to keep the $230 premium, so your total profit is $1,230 ($230 premium + $1,000 profit from selling the stock).
Step 4: Repeat the process
If the option expires worthless, you can repeat the process by selling another call option on your 100 shares of Amazon stock.
Risks and Rewards of the Covered Call Strategy with Amazon Stock
The covered call strategy with Amazon stock can be a good way to generate income from your investments while limiting your downside risk. However, there are some risks and rewards to consider.
A popular opinion regarding the risk of the covered call strategy is that if the stock price goes up significantly, you may miss out on potential profits. In the example above, if the stock price went up to $150, you would have missed out on $40 per share in potential profits. I
wouldn't actually say this is a bad outcome, as you still make a profit. The real risk with covered call writing is quite opposite, which is the stock drops significantly. In the example above, if the stock price went down to $50, your options would expire worthless, and you would keep the premium, but you would find it also very hard to recover from this trade for the months to come.
The main reward of the covered call strategy is that you can generate income from your investments without taking on too much risk. In the example above, you received $230 in premium upfront, which is a 2.3% return on your investment in just one month.
The Bottom Line
A covered call strategy with Amazon stock can be a useful strategy for investors who want to generate income while limiting their downside risk.
By selling call options on Amazon stock, investors can receive premiums upfront, and if the stock price stays relatively stable or goes down, they can keep the premiums without having to sell their shares. However, investors should be aware of the potential risks, such as missing out on potential profits if the stock price goes up significantly.
Overall, the covered call strategy can be a good way for beginners to dip their toes into options trading while also generating income from their investments. As always, it's important to do your research and consult with a financial advisor before making any investment decisions.
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