Selling a covered call or a put option is technically a form of shorting, but it is a very different investment strategy than actually selling a stock short. In this Nov. 17 Fool Live video clip, Fool.com contributors Matt Frankel, CFP, and Jason Hall answer a listener's question about the difference between covered calls, selling put options, and shorting stocks.
Jason Hall: Let's do that one. JD said, "I've been selling covered calls to generate income. Would this be considered shorting? Same question for selling cash-secured put positions."
Matt Frankel: The cash-secured put options, if you sell puts, first of all, that's a bullish strategy. That wouldn't be a form of shorting.
Jason Hall: Selling a put, it's short puts. Yeah, you're shorting the put, but shorting a put is as long as it gets because you are creating an obligation to buy a stock at a price in the future no matter what the actual market price of that stock is. You are shorting the option but it's as long on the stock as you could possibly be.
Matt Frankel: I think covered calls are even mildly bullish strategy because you're betting a stock is going to go up and stay under a certain price. If it doesn't, you're just going to make money.
Jason Hall: Then you're just going to make money.
Matt Frankel: The most money you're going to make is if the stock goes up [...].
Jason Hall: Because you get the premium. To explain to people what a covered call means, I think that's important. A covered call means you own a stock and you are selling an option to somebody else to buy that stock at a certain price. There's a buyer, somebody's buying that call on the other end that says that they will pay X for that stock at some future point. They may or may not execute that option to do that. Am I getting that right?
Matt Frankel: Yeah. You got it.
Jason Hall: But the thing is if the stock price goes up, that premium is essentially worthless on the other end, right? Help me out here. I'm doing something wrong in my head.
Matt Frankel: Covered calls are definitely an income generation strategy and options contracts are always priced in hundreds of shares, usually.
Jason Hall: Some are in tens, but most are in hundreds.
Matt Frankel: A real-world example. Let's say I own about 100 shares of Apple (NASDAQ: AAPL) in my portfolio. Apple is at about 120. I might sell somebody the right to purchase those shares for $130 anytime in the next few months. If the stock stays under $130, the call expires worthless. I keep my stock and I get to keep the premium that they paid for that right. If it goes above 130, I get called out of the stock. I still get $130 each of my shares, which is a gain over what I have today. I get to keep the options premium but I lose any upside over $130. So if the stock goes to say 160, it's a losing strategy. But you still make the most money when the stock goes up, when you're issuing a covered call.
Jason Hall: When it goes up enough, that's the key, right?
Matt Frankel: Right. It could be a great way to get income out of some of your more stable stocks.
Jason Hall: That's the key.
Matt Frankel: I've actually written covered calls against my Apple shares in the past few months. I don't have any right now but I have done that against Apple shares to generate a little bit more income. But it could be a good income strategy. I would not consider it shorting. It's not a bearish strategy. If I had a negative outlook on Apple, I would just sell my Apple shares. You're technically shorting an option but it's not the same thing as shorting the stock.
Matt Frankel: The idea is something that's pretty popular, and you hit on a good thing. It's something usually that's really good at applying to stocks that typically have more of a stable value and don't have a really big Beta, in other words, they're not super volatile. Sometimes, you can fall for that and you can sell covered calls on a really volatile stock because the premiums are juicier, but there's less predictability what the price is going to do, and you might get called out of a stock just because you got a little bit greedy. But it's popular. Berkshire Hathaway (NYSE: BRK.A)(NYSE: BRK.B) is a great example. It's a great stock to own, but a lot of people that like it are looking for income, and Berkshire doesn't pay a dividend. So selling covered calls on Berkshire B shares can be a popular way to own that stock and also make some income from it.