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What is a Covered Call? You own stock shares, and you sell calls at a strike greater than or equal to the stock purchase price. You profit if the stock rises or moves sideways but your upside profit is limited. You lose if the stock moves somewhere below your initial stock purchase price. The loss is offset by the sell call credit.
Here is a summary on how you can put covered calls to work for you.
Covered Calls
The basic covered call is a relatively simple strategy. The owner of a security sells the right to have their security purchased at a predetermined price in the future in return for money now. If the security price does not fall over the life of the option, the call writer will keep the premium collected when the call was sold. The call writer’s profit is limited in exchange for the premium.
Strategies for covered call writing depend on the objective.
· Supplement Return
Covered call writers interested in supplementing the return of existing holding will tend to sell covered calls out of the money. The expectation is not that the security price will rise, but that it will not fall. The seller of out of the money calls often expects to continue holding the security, but hopes to reap some extra return from the proceeds of selling the call.
· Hedge Against Loss
Covered call writers can protect against downside price movement by selling in the money calls. This is commonly done after a rise in a security that is already held, to protect some of the gains that were already made. Although less time premium is collected on the call, the risk of loss is lessened by the amount that the call is in the money.
· Speculative Strategies
There are strategies that set objectives such as Doubling in 2 Years, or earning 10% a Month. A portfolio can be doubled in two years by successively selling covered calls that return 50% time premium for a term that last approximately 1 year. It is also possible to sell covered calls that return 10% in approximately one month. Both of these strategies require that the underlying stock price is at or above the strike price at expiration, and that this goal can be achieved repeatedly. Theoretically, a stock will lose some value 50% of the time.
How to interpret these lists
Each list is sorted by the Return Rate to Expiration. As you can see, some covered calls can produce a potential annualized return rate of 75 to over 100% – so you can see why this is such a lucrative endeavor! Second consideration is the probability of a profit.
Probability of Profit is the probability that the predicted stock price falls within the option trade’s profit zones. The predicted stock price distribution is computed by projecting the stock price randomly into the future using the SV.
Upside Breakeven: An option trade almost always has a point where the value of the trade goes from losses to profits. The stock price where the profit crossing occurs is referred to as the breakeven price. Many option spreads have two breakeven prices. The higher breakeven price is the upside breakeven and is usually above the stock price. The downside breakeven price is the lower stock price crossing of the option expiration risk curve.
How to trade a Covered Call
By selling a call you grant the buyer the right to buy 100 shares of the underlying stock or index at the strike price any time prior to expiration. You receive the option premium from the call buyer, and the brokerage house takes its cut from both of you. The actions that may occur include: you later sell the option, the option expires and you keep the premium, or the buyer exercises the call and you must provide the shares.
You own 100 shares of a stock or index. Using TXN in the prior example, you decide you would not mind selling it at an option Strike price of 110. Your desired strike price is 110. You sell a TXN Jan00 call at 110. Owning the stock and selling a call is an example of a covered call option trade.
In this covered call option trade you receive 3.25*$100 = $325 dollars into your account (minus brokerage commissions). The Jan00 110 call on Dec 10 has no intrinsic value; hence the $325 is all time value.
If the buyer of the call never exercises it before expiration, you get to keep the $325 dollars, the option premium, and your TXN shares. If the buyer of the call exercises it, you sell your TXN index shares at 110 to the buyer and again keep the $325 premium. You might wonder how a covered call loses money. The call buyer probably exercised the option, because TXN rose above the 110 strike price. The call seller does not participate in price movement above 110 and also loses the 100 shares of the stock.
· Risks of Covered Call Writing
Writing covered calls is generally considered a conservative option strategy. This only holds true if covered calls are written on conservative stocks. The covered call writer will suffer losses if the underlying security price drops. The most significant measure of this risk is the volatility. Writing covered calls on stocks with low volatility is conservative. Writing covered calls on highly volatile stocks is inherently more risky.
· Effect of Dividends on Calls
When a stock pays a dividend, the price of the stock is reduced by the amount of the dividend. For example, if Frontline (FRO) closes at 41.50 and pays a $2.00 dividend, the open price will be adjusted downward prior to the open to $39.50. There may appear to be an advantage to the call writer, since it is known that the price of the stock will drop. Why not sell the $40 call when it is known that the stock will drop $2? The short answer is that the call is discounted to reflect the impending drop in the stock price.
Regards,
Investment Research Group, Inc.
www.stockbarometer.com
