Covered Calls

Covered Calls

The primary objective of the covered call writer is increased income through stock ownership.  Coupled with that is the desire to minimize inherent risks of the market.

There are various strategies for covered call writers.  Some strategies could satisfy the most conservative investor while others would challenge the most aggressive.  We at Stricknet.com offer this tutorial to teach some of the strategies that are relatively unknown by the vast number of covered call writers.  We do not contend that this is an all-inclusive authority on the subject, but we do challenge anyone to find a source on the internet to offer such advanced and well-reasoned strategies.  These are not new strategies, but they are largely unknown, even among those who trade covered calls on a regular basis.   Further we do not intend for this to be a beginner's course.  We assume that the reader has some understanding of how covered calls actually work and a basic knowledge of the terminology used.  We will review a simple covered call transaction before we get into the more advanced, but this review alone should not be considered a basic training on the subject.  There are many good books which you could read for that.

All covered calls involve selling an option on a stock that you currently own.  But there are two broad terms that "categorize" your position: In-The-Money and Out-Of-The-Money.  If you own a stock that is trading at 19 and sell the 20 call, then the option is deemed "out of the money".  There is no intrinsic value in the option.  The only value it has is time value.  If you sold a 15 call on the 19 stock that you own, then the option is said to be "in the money".  It is in the money by 4 dollars.   The option of course would be worth more than 4, depending on the amount of time left before expiration.

Typically, writing a covered call by selling an out-of-the-money option offers the highest returns, while writing a covered call with in-the-money strikes offer the highest degree of safety.  The deeper in the money the safer.  There are also combination strategies to maintain a high degree of safety, and obtain higher yields as well.

Covered Calls

Example: ABC stock is selling for 22 1/2 and the January 25 call is selling for 1. If you were to buy the stock for 22 1/2 then sell the $25 option you would receive the premium for the option and have the potential capital appreciation in the stock, up to the strike price of 25. So you could earn 3 1/2 points on this trade. If you purchased one round lot (100 shares) and sold one contract your return would be $350. Now if you maximized your leverage and purchased the stock using 50% margin, you would purchase the stock for $1125. So the gain of $350 on an $1125 investment equals 31.1% return. That is assuming the stock price rises to at least 25 and you're called out. Any gain above the strike price doesn't benefit you, but the holder of the option.

If the stock price remains flat until expiration and you aren't called out, you still earn the option premium of one dollar. So a $100 return on an $1125 investment equals 8.8%, even if the stock price doesn't move. At the expiration you can then sell another option or sell the stock and look for another one.

But wait! What if the stock price falls? That's always the risk, isn't it? But even then, the price could drop to 21 1/2 and you'd still break even. You gained the $1 premium for the option. It is this principle that makes covered calls safer than most investments.

But what if the stock price falls below the break-even point, you're doomed right? Not necessarily. There are some protective actions you can take. The simplest thing to do is close out the position. This should be your action if you think the price will continue to decline. Bite the bullet, pull the trigger, move on. Another action you could take is roll down. When the underlying stock drops in price, buy back the original call -- it will certainly be less than you sold it for since the underlying stock has declined -- then sell a call with a lower strike price. This could give you some more downside protection and might turn the deal into a profit.

Example: If you bought ABC stock for 25 1/2 and sold the May 25 call at 3, you would have maximum profit potential at expiration of 2 1/2 points. Your downside protection is 3 points, down to a price of 22 1/2. If the stock price drops to 22 1/2 the May 25 call might be selling for 1/2, and the May 22 1/2 call might be around 2. At this point, you'd be 2 1/2 points below the strike price and have a 1/2 point unrealized loss. If the stock should continue to fall from this level, you could have a greater loss at expiration. What to do? Here's one salvage technique. You could buy back the original call for 1/2 (you sold it for 3, remember), then sell the 22 1/2 call for 2. Now your downside breakeven point is 21 since you rolled down.

Further if the stock remained unchanged (exactly at 22 1/2) until expiration you would make an additional $150. If you had not rolled down, and ABC remained at 22 1/2, the most you could have made would be the remaining 1/2 from the May 25 call. So rolling down gives you a little more downside protection and might produce additional income if the stock price firms.

The only time it doesn't pay to roll down is when the stock reverses and begins to climb. There just is no way around the equation: lower risk = lower potential return, higher risk = higher potential return.

What if the stock rises? A more pleasant problem to deal with is one in which the underlying stock rises in price after the covered position is in place. You might decide to do nothing and let the stock be called away, thus earning exactly what you anticipated when you entered the position. On the other hand, you might try to squeeze another point or two out of it. Let's say you bought ABC stock for 25 and sold a Nov 25 call for 3 points. Your maximum profit potential is 3 points and your breakeven point is 22. Suppose the stock rallies to 30 in a short period of time. With the stock at 30 the Dec 25 might be selling for 5 1/2 and the Dec 30 might sell for 3 1/2. What you might consider is buy back the original Dec 25 call for 5 1/2 and sell the Dec 30 for 3 1/2. This would increase your profit potential. In your original position, if ABC were called away you would have earned 3 points. By rolling up you would have earned the original 3 points plus the 3 1/2 points gained in the roll up, minus the 5 1/2 you had to pay to buy back the original call. You also would gain the 5 points increase in the stock price. So add the 5 points earned on the stock plus the 1 profit on the options, and your net return is 6 points, as long as the stock remains above 30.

To increase your profit potential in this manner, you give up some of your downside protection. This element of risk should always be considered. Generally you should not roll up if you think the stock can't handle a 10% correction and still leave you in good shape.

Covered Calls

Covered call writing is generally considered to be a conservative strategy. This is because the covered writer would fair better in a stock decline than the stockholder who won't receive any premiums from covered writes. But clearly, some covered writes are more conservative than others.

It may be surprising, but writing an out-of-the-money option on a conservative stock is NOT as conservative as writing an in-the-money option on a volatile stock. An in-the-money write, when properly chosen is a totally conservative position. Now surely, you can't write them too deeply in the money allowing for total protection, the yields would be so low that you might as well leave your money in the bank. The conservative covered call writer strives to make an above average return with above average protection.

Example: Assume ABC stock is selling for 22 1/2 and the Jun 20 call is selling at 4. By using leverage from your margin account, the stock could be bought for $1125. You would receive $400 for the option. When you're called out you will have to sell your stock for $20, that's 2 1/2 points less than you paid for it. So your net is 1 1/2 points ($150) on an $1125 investment. That equals 13.3% yield. Now look at the protection you have. The stock price can fall 2 1/2 points and the trade still work out as planned. You will be called away and you've earned the premium. If the stock is at-the-money and you're not called out, then you can sell the stock or do another covered write.

Your breakeven point is 18 1/2 which means the stock would have to fall nearly 20% for this to turn into a losing trade. The downside to in-the-money covered calls is that you don't benefit from any upside potential of the stock. But in a flat market, or even a bearish market, there is great comfort in those in-the-money covered calls. Great comfort. Many investors reconcile themselves that they are after 8-15% per month and want safety first. They never concern themselves with the rising price of a stock. They simply want to get called out of their position and look for another trade that will earn them another 8-10% in a month or so, and they consistently have yields of 100% per year.

Calls

Success in call buying primarily depends on your ability to select stocks that will go up in price and to time your selection fairly well. Most investment strategies are designed to remove some of the risk and exactness in stock picking, thus allowing you to have some room for error and still make a profit. But that doesn't exist with pure play call buying. Your total investment could be lost in an option play, even if the stock goes up. It has to go up enough and quickly enough to be profitable. For this reason, one should only use risk money when buying calls. The potential rewards in buying calls are so attractive to many investors and speculators that it is the most used options strategy by the investing public.

The attraction of call buying is the leverage it gives a speculator. One could potentially realize large percentage profits from only a modest rise in price by the underlying stock. And even though they may be large percentage gains, the risks cannot exceed the fixed amount paid for the option originally. Calls have to be paid in full and cannot be bought on margin. Nor do they have any margin value nor contribute any equity to your margin account.

Illustration of how a call purchase might work:

Assume that ABC stock is selling at 48 and the 6-month call, the July 50, is selling for 3. With an investment of $300, the call buyer may participate, for 6 months, in a move upward in the price of the stock. If ABC should rise in price by 10 points (just over 20%), the July 50 call will be worth at least $800 and the call buyer would have a 167% profit on a move in the stock of just over 20%. This is the leverage that attracts speculators to calls. At expiration, if ABC is below 50, the buyer's loss is total, but is limited to his initial investment of $300, even if the stock declines substantially. Although this risk is equal to 100% of his investment, the dollar amount is still small. You should never risk more than 15-20% of your risk capital in call buying because of the high percentage risks involved.

Some investors invest in call options on a very limited basis to add some upside potential to their portfolio. While investing in conservative stocks, and covered calls, they invest a small portion in buying calls on more volatile stocks. The investor will have a limited dollar risk by owning the option instead of the stock.

It is very important to understand that the buyer of calls will only make money if the price of the underlying stock goes up.

Calls

The cold, hard fact for the call buyer to recognize is that you will only make money if the stock rises in price. All the analysis in the world trying to decide which option to buy will not produce profits if the stock declines. However, this fact shouldn't dissuade you from making reasonable analyses in your call buying selections. Further, many times a speculator will pick the right stock, but the wrong option. The stock will go up, but not enough to be in-the-money, or not soon enough (prior to the expiration of the option).

Since the only ally the call buyer has is upward movement in the underlying stock, the selection of the underlying stock is the most important choice you have to make. Since timing is so important too, technical analysis and current news, are more reliable indicators than fundamentals. You must be bullish on the stock to consider purchasing calls. Only after the stock has been selected can you begin to consider other important factors, such as strike price and expiration months.

The purchase of an out-of-the-money call has both greater potential gains and risk than does an in-the-money call. Many call buyers will only buy out-of-the-money calls simply because they are cheaper. But the dollar amount should never be the deciding factor for which option to buy. If your funds are so low that you can only afford to buy out of the money calls, then you should not be investing in calls. The risks are too great. If a stock advances substantially, the out of the money calls will provide the best returns, but if it only advances moderately, then the in the money will perform better.

Example: Assume ABC stock is at 60, the December 55 calls are at 5 and the Dec 65 calls are 2. If the stock moves up to 63 relatively slowly, the Dec 65 (out of the money) calls may actually experience a loss, even if the call has not yet expired. But the Dec 55 (in the money) calls will definitely have a profit because the call will sell for at least 8 points since that's its intrinsic value. So percentage-wise, an in the money call will have a better return if the stock moves modestly, while an out of the money call will have a better return if the stock moves up a great deal.

An in the money call clearly has less risk.

Timing is also a critical element. If you're relatively certain the stock will move up in the near future, then a short-term option offers the best deal. You won't be paying as much in time-premium. But if you're uncertain about the timing, then a farther out option is the better strategy.

Covered Calls

The delta of an option is the amount by which the call will increase or decrease in price if the underlying stock moves by 1 point. The delta of a stock is close to one when your call option is deep in the money. If ABC stock is trading at 90, and your Dec 80 call is at 10 1/8, then your option will change in price nearly 1 point for every 1 point move in the underlying stock. But if your option is deeply out of the money, the delta would not be close to one. Let's say that ABC is trading at 90 and you hold the Dec 95 call. If the stock goes up 1 point, your call might go up only 1/2 point. The delta changes with each price movement of the stock. If your calls are out of the money, as the stock goes up, the delta will get closer to 1. Conversely, if you are deep in the money, and the price of the stock begins to decline, then the delta will begin to move away from 1.

Calls

There's a complex formula for determining the volatility of an option, which in turn, determines the "fair value" of an option. It is far too complex to address here, and I have found very little use for it. It is not in my best interest to purchase an option based on the premise that is "cheaper" than it should be, just to watch it get cheaper. Likewise, if I'm ready to move in to a position and the option is 1/4 of a point higher than it should be, I'm not going to pass up my trade because the market makers have the option slightly 'overpriced'. Institutions rely heavily on volatility, but their volume, commission structure, and methods are quite different from an individual investor. If you have an interest in the mathematical formulas and the theories behind option-pricing, there are many good books on the subject.

[Covered Calls] [Naked Puts]
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Naked Puts

Naked Puts

Selling puts is a bullish or neutral strategy where profits are earned by receiving premium for the put option. Not everyone can sell naked puts. First your broker is going to want to know if you have any experience with options, and he's going to require a certain amount of cash or equities in your account, and that amount can vary from broker to broker.

This review is not intended as an in depth study on the subject, but as a brief review. If you have an interest in selling naked puts, I suggest you first begin by studying the subject. Don't just dive in. There are many good books available on the subject.

Let's work through an example. On Sep 18th Compaq Computer closed at 30 5/8. The Oct 35 Put closed at 4 5/8. If you're bullish on this stock you could do several things. But we'll discuss a bullish position by selling puts. If you thought the stock would reach or go beyond 35, you'd sell the Oct 35 Put.

Once your brokerage account is set up and funded, you would call your broker (or do it online), place an order to sell the Oct 35 Put. This is a "Sell to Open" order. You are selling something to open a position. If you sold 10 contracts, $4,625.00 would be deposited into your account the next day. This will show up as a short position on your statement from your broker.

Now, if the stock has risen above the 35 strike price on expiration day, the option expires worthless and the entire $4625 is yours to keep (less commissions of course.) But you don't have to wait until expiration date to do something with it. If you sold options at 4 5/8 and the stock price jumped very quickly such that the option price has now fallen to 1 or 1 1/2, you can buy them back and close out the position. Your profit is the difference in what you sold them for and what you had to pay to buy them back to close the position. Frequently, options are sold many times prior to expiration date.

What happens if the price of the stock drops after the position is opened? First, if you're the seller of the puts, and you haven't closed out the position on expiration day, the stock can be put to you. That means you have to buy the stock at the strike price. If you sold the Oct 35 Put and the price of the stock fell to 29, you'd have to buy the stock for 35. Of course, the cost of the stock would be offset with the premium you received in the first place.

You could choose to buy the put back just before expiration so that the stock would not be put to you. The Put price would be 6, and maybe a little change, since the put is 6 dollars in the money, right at expiration. You sold the puts for 4 5/8, had to buy them back for 6, so you have a loss of 1 3/8, right? Well that's right if you leave it there, but a salvage technique is to buy the put back for six, then immediately sell the next month put at the same strike price. You'd sell the November 30 put for 6 dollars (the intrinsic value) plus you'd get additional premium for the time-value. So the put might sell for 8 dollars. Now you've got another month for the stock price to rise. If it rises above 35, at expiration the option would expire worthless and the premium is completely yours to keep. This cycle could go on many times.

Selling puts can be very profitable, but like all option trading there is risk. It is possible to sell a put, and the stock price fall to zero. Your liability would be the entire strike price. Now let's be real, how many stocks really fall to zero? Not many, but it can happen. So when choosing the stocks on which to sell puts, use the same care that you would if you were buying call options.

Naked Puts

Unlike many investments where the yields are simple and concrete, yields from Naked Puts can be more difficult to figure, and will vary from broker to broker, depending on his margin requirements. The yields listed in our Naked Puts section are calculated on a 30%+ margin requirement. Many brokers' margin requirements are less than that, so your yields could be even greater that listed.

Ameritrade is one of the large online brokers and in their MARGIN ACCOUNT HANDBOOK margin requirements are spelled out as follows:

"The writing of uncovered puts and calls requires an initial deposit and maintenance of 100% of the current market value of the contract plus 30% of the underlying stock value less the out-of-the-money amount, if any, to a minimum of the option market value plus 10% of the underlying stock value."

This rather complicated formula really isn’t that difficult to understand. Basically, your broker will require 30% of the stock price plus the cost of the option to sell a put that is at the money. If the option is out of the money, then they’ll give you credit for the out of the money portion. Armed with that info we can calculate what the yield would be if we were to sell various options.

Example: Let’s say that ABC stock is selling at 42. It’s the end of July and the August 40 Put is selling for 1 7/8. If we wanted to sell the Aug 40 Put, our broker would require on deposit the following funds: 30% of the stock price (which equals $12.60) plus the cost of the option ($1.88), minus the out of the money amount ($2.00) -- 12.60 + 1.88 – 2.00 = 12.48 Since one option is for 100 shares of the underlying stock, then 12.48 * 100 = $1,248. Your broker will require $1,248 cash or equities in your account to sell 1 Jan 40 Put option. The premium you’d receive is 1 7/8 * 100 = $188. To figure your yield divide $188 by $1248, and you get 15%. So as long as the stock price remains above 40, you’d keep the entire premium and earn 15% in one month. This is a very lucrative from of trading. When you compare it to buying options, it can be safer as well. The stock would have to drop below 40 for your yield to be less than 15%, and could drop all the way to 38 1/8 and you’d still break even (commissions not included).

[Covered Calls] [Naked Puts]
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