I am always striving to find simpler ways to explain investing and strategies to clients and students. The markets are a complicated arena, and it almost feels like the industry tries to keep it that way. Today I would like to simplify the use of covered calls with a simplified analogy.
Imagine for a moment that all the investments in your portfolio are all homes, and not mutual funds, stocks, and bonds.
Let's pretend you have 3 holdings (homes) in your portfolio and that you rent them out each month for a small fee.
- The risks are that someone doesn't pay the fee, damages your home, or maybe the home is damaged by a natural disaster.
- The rewards are that the fee you charge (assuming it's paid on time) can help you pay down your cost basis, and maybe generate some extra income in the meantime. Who knows, maybe one day the people renting your house will want to buy it from you.
Taking the same approach with your investments -
Well, with your market investments you can do the exact same thing, only in this case you do not have the same risks. Pretend you have 3 stocks in your portfolio. (presumably with enough activity and volume to use options)
- The risks are that the positions you own will lose value, but you already own these names and were comfortable assuming that risk when you initially bought them. So let's say you "rent" them out while you hold them. In this case there is no risk of a late payment, and you most likely will not be hit by raining men. This is because the middle man (your brokerage firm) will handle all that for you.
- The rewards are the same as our example above. You get paid a small fee while you hold the investments, which helps you lower your cost basis and generate income. Even better, if someone wants to buy your investment from you, you will already know the price you are selling at.
As you may be able to tell, we are talking about the use of covered calls. These can be a great, simple addition to your long term investments. We offer many articles on this site to help you learn more.
