If you’re new to investing, you may have heard of covered call writing, but not know exactly what it is. Covered call writing is a conservative investment strategy that allows you to generate extra income from your investments.
When you sell a covered call, you give another investor the option to purchase 100 shares of stocks you own at a certain price, which is known as the strike price. In return, you’ll collect a premium that you get to keep regardless of whether or not the option is exercised by the expiration date.
If the buyer decides not to purchase your shares, you’ll also get to keep them and maintain your position. Although this sounds like a great deal, there are some downsides to this investment strategy. Read this before selling covered calls so you’re aware of the pitfalls.
Read This Before Selling Covered Calls
Selling Covered Calls Limits Your Profit
One of the disadvantages of selling covered calls is that it limits your profits. If the stock price rises above the strike price, the buyer will probably exercise the option. After all, who wouldn’t want to buy stock at a lower price than its current value? This means you’ll lose out on the extra profit you could’ve made if you didn’t sell covered calls.
If the stock only rises by a few dollars, you may not feel like you’re missing out. But if it shoots up substantially, you might have regrets about choosing this investment strategy. So make sure you pick your stocks wisely.
You may want to avoid selling covered calls on stocks you expect to surge in price. Additionally, you should only agree to sell your shares for a price you’re comfortable with to avoid disappointment if the buyer does exercise the option.
Covered Calls Still Involve Risk
The premium you earn from selling covered calls can offer some protection against loss. For example, if you earn a premium of $3 per share for selling a covered call on a stock you purchased for $60 per share, your cost basis is reduced by $3. Your breakeven point on each share will be $57 instead of $60, which puts you in a better position than other investors.
But premiums may only be a few dollars per share, so they offer limited protection. If the stock’s price falls, there’s still a chance you’ll lose money. Although selling covered calls is considered a conservative strategy, it isn’t without risk, so keep that in mind.
You Might Have to Pay Capital Gains Tax
If the buyer decides to exercise the option and purchase your stock, you’ll have to pay taxes on the transaction. The amount of capital gains tax you’ll pay depends on how long you’ve held the stock and how much income you earn each year.
Short-term capital gains are taxed at a higher rate than long-term. So it may be worth it to hold onto your shares for a year before selling them to qualify for the lower long-term capital gains tax rate.
Selling covered calls is a great way to add extra income to your portfolio. This strategy allows you to collect premiums on top of the dividends you’re already earning from some of your investments. And if the buyer doesn’t exercise the option, you’ll get to keep your stocks, allowing you to sell even more covered calls if you choose to do so.
But this strategy isn’t without risk, so consider your investment decisions carefully.
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