Understanding Covered Call Writing in Dividend Investing

Financial derivative conferring the right to to buy or sell a certain thing at a later date at an agreed price.

Covered call writing is an advanced income strategy that can be used to enhance the returns from a dividend investing portfolio. This article will provide a comprehensive overview of covered call writing, including its definition, how to write a covered call, its risks and benefits, and real-world examples.

What is Covered Call Writing?

Covered call writing is an options strategy where an investor sells, or "writes," call options against shares they already own. In essence, the investor is selling someone else the right to buy their shares at a specified price, known as the strike price, within a certain period.

How to Write a Covered Call

Writing a covered call involves several steps:

1. Own the Underlying Stock: Before you can write a covered call, you must own the underlying stock. This is what makes the call "covered." If the call option is exercised, you can deliver the shares you already own.

2. Choose the Strike Price and Expiration Date: The strike price is the price at which the call option buyer has the right to purchase the shares. The expiration date is the date at which the option contract expires.

3. Sell the Call Option: Once you've chosen the strike price and expiration date, you can sell the call option. The income you receive from selling the call option is known as the premium.

Risks and Benefits of Covered Call Writing

Covered call writing comes with both risks and benefits.

Benefits:

• Income Generation: The premium received from selling the call option can provide additional income, enhancing the returns from your dividend investing portfolio.

• Downside Protection: The premium received can also provide some downside protection. If the stock's price falls, the premium can offset some of the losses.

Risks:

• Limited Upside Potential: If the stock's price rises significantly, you may have to sell your shares at the strike price, missing out on potential gains.

• Potential for Losses: If the stock's price falls significantly, the premium may not be enough to offset the losses.

Real-World Examples

Let's say you own 100 shares of a dividend aristocrat stock currently trading at 50 per share. You decide to write a covered call with a strike price of 55 and an expiration date in one month. You sell the call option and receive a premium of $200.

If the stock's price stays below 55, the call option will expire worthless, and you keep the premium as income. If the stock's price rises above 55, the call option may be exercised, and you'll have to sell your shares at $55 each. However, you still keep the premium.

In conclusion, covered call writing can be a useful strategy for enhancing the income from a dividend investing portfolio. However, it's important to understand the risks involved and to use this strategy judiciously.