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Covered Call Writing - The Basics

Covered call writing is the most common option strategy currently in use today. It is generally considered a conservative income strategy and is safe enough that most brokerages allow the strategy to be employed in individual retirement accounts. It is a simple strategy where one buys one hundred shares of a particular stock and then subsequently sells a call option with a specified strike price. Easy, right? Well, just in case you haven't been flipping through your Series 7 study guide or haven't really explored the world of options, let me break it down for you.

With every option contract there are two parties involved. One person is selling (writing) the contract and one person is buying it (going long). The person who sold the contract is agreeing to deliver one hundred shares of a given stock at a specified price, which is called the strike price. For example, say Apple is trading at $135 per share. A person writes a contract for one hundred shares of Apple with a strike price of $135 and an expiration of nine months. Now, the person who bought the call option can now wait up to nine months before purchasing one hundred shares of Apple at a locked in price of $135 per share.

The Buyer of Options

To understand why a transaction like the one above would take place, it is necessary to examine what each party of the transaction is hoping to accomplish. Since the reasoning behind greed, risk, and the pursuit of outrageous returns is always more entertaining to delve into, we'll start with the person who purchased the call option. The most common reason that a person would purchase a call option is because of the incredible leverage it offers.

Say a stock is trading at $20 per share. To buy one hundred shares you would have to have $2,000 in capital. Say you don't have $2,000. Well, what you could do is buy a call option with a $20 strike price which currently has a premium of one dollar. We'll get into the details of a premium in more detail later, but with the call option trading at one dollar, you would multiply that one dollar by hundred shares and that would give you the cost of the call option. So, for the low price of one hundred dollars you now control one hundred shares of stock.

Now that you control those one hundred shares of stock, you must remember that the two most important things to a person who buys call options are the break-even point and time. Just in case anyone is thinking that this is rocket science, you get a short reprieve. The reason the break-even point is important is because it is the point where you break even. The definition of the break even point is when the price of the stock is equal to the strike price plus the premium. In our example the break-even point is $21. Simply the strike price of $20 plus the $1 premium per share you paid to have the right to buy each of the hundred shares at $20 a piece. The fun part, the part where leverage comes into play, fortunes are made, and even Donald Trump gets a little envious is when the price of the stock goes over the break-even price. Sticking with our example, assume the price of the stock climbs to $22 per share. You know what that means? It means you just doubled your money. How? With the call option you have the right to buy one hundred shares at $20 per share. With those shares trading at $22 per share, that's a two hundred dollar difference. Considering that you paid $100 for the right to buy those one hundred shares at $20 a share, you just turned your one hundred dollars into two hundred dollars. It gets better: for every one dollar the price of the stock increases, you make one hundred dollars. If the stock price shoots up to $30 then your call option is now worth $1,000. Just in case you want the math one more time, you can buy 100 shares of the stock at $20 so it would cost you $2,000. With the stock trading at $30 per share, you could exercise the call option, pay $2,000 for the 100 shares, then immediately sell them in the marketplace for $30 per share, giving you a $1,000 profit. The great part about owning an option is that instead of being forced to exercise the option and come up with $2,000 you can just sell the call option to someone else and they can exercise it and come up with the $2,000.

As you can see from the previous example, the leverage that is provided by buying call options is potentially huge. There has been a "story" in circulation for years about a man who bought a large number of Cisco Systems call options in the late '90's. This of course was during the internet bubble and he would call in every day to see how much his balance had gone up. His account had originally started in the six figures. At the peak it was in the very low nine digits. He took a huge risk, made a massive bet, and it paid off. Of course, the story doesn't end with him selling all of the options and cashing in for a hundred million dollars. No, greed is always a temptation so he rode the value of those contracts all the way back down until his account was a little under twenty million. Google and Apple are two of the more recent examples of people buying out of the money call options and making small fortunes. The question then becomes, why aren't more people making fortunes with options?

The simple answer is time, which is the other extremely important thing to anyone who dabbles in the options market. Time is the limitation on your leverage. Once the contract expires, you no longer have control over those one hundred shares. When it expires, you no longer have the right to purchase one hundred shares at a particular price. So remember that $100 premium you paid for the call option for the company trading at $20 per share? Well, when the call option expires, the person who sold you that call option gets to pocket the one hundred dollars and no longer has any obligation to you. That premium is the reason people are willing to write (sell) a call option. Which brings me back to the reason that time is one of the major determining factors when dealing with options. With enough time, and assuming the company continues to grow, the stock price will eventually appreciate and surpass your break-even point. Then the leverage would kick in and you would have your fortune. The problem of course is that you have at most nine months for that stock price to appreciate and the longer the time frame that you have, the higher the premium that you're going to pay to control those one hundred shares.

The price that you pay for the premium, which is the price you pay to have the right to buy one hundred shares at a specific price, is made up of two components, intrinsic value and time value. Intrinsic value is the difference between the strike price and the current price. For example, say you have a call option with a strike price of $100 and the stock is currently trading at $110. Of the total premium you would pay, the intrinsic value component of the premium is $10. The other part of the premium is the time value. Time value is the cost you pay to compensate the person who wrote the call to give up the potential gains of the stock before the option expires. To put the two together, say you paid a $15 premium for a call option with a strike price of $100 and the stock is currently trading at $110 per share. The intrinsic value of the call option would be $10 and the time value would be $5.

Paying the premium gives you control over one hundred shares of stock for each contract you buy. While leverage and the possibility of massive returns is the most common reason people buy options, there are several other reasons that I'll quickly go over. The first reason is that someone might want to lock in the current price of a stock, doesn't have the money to buy the shares outright but will receive the money to cover the cost of the shares in the near future. Another reason, one that is most commonly found when rumors are floating around about a company, is that a person thinks something is going to happen, such as a new blockbuster drug approval, which will cause the stock price to shoot up. They don't want to buy the actual shares because the company happens to be a one hit wonder and if the drug is not approved, then the stock price may fall significantly. By purchasing a call option, the person sets themselves up to profit greatly if the drug is approved while still greatly reducing their downside risk if it is not approved.

The Seller of Options

So have I talked you into putting your entire retirement account into out of the money call options? No? Good. Because if you're wrong about the direction of the stock or how long it'll take to go in that direction, then you just lost the entire investment. With that cheery thought, let's take a look at the other side of the option transaction which is the person who writes (sells) the contract and promises to deliver one hundred shares at a specific price in nine months if you choose to exercise that option during that time. In return for guaranteeing you that particular price and giving up the possible gains for that particular time period, all they ask is for a little compensation. Does it sound like the person writing the call has been cheated? Stay with me because it's possible for the person writing a covered call to have fairly consistent gains ... as much as ten and even twenty plus percent per year.

The difference between writing a naked call and writing a covered call is the difference between owning one hundred shares of the stock which you've promised to deliver at a specific price and not having those shares. When you write a naked call, you are exposing yourself to limited gain and unlimited loss. For example, if you write a naked call you will receive a premium which will probably be a couple hundred dollars per contract. That couple hundred dollars is the most you can make. As long as the stock price stays flat or decreases you'll have no worries and the couple hundred dollars will go straight into your pocket. Unfortunately, if the stock price goes up, you are exposed to unlimited loss. What if you were the one who promised the shares of Google at $100 per share during the time it shot up to $400? Well, you would have to buy 100 shares of Google at $400 so you could deliver your promised 100 shares. Since the strike price of $100 per share, you would only receive $10,000 and would be looking at a loss of $30,000.

A covered call on the other hand will cap your maximum loss. The maximum loss on a covered call writing strategy is defined as the cost of the one hundred shares of stock minus the premium received. So, back to the earlier example of the company trading at $20, say you bought one hundred shares at $20 a piece and then you sold a call option that had a premium of one dollar. Well, your maximum loss is $2,000 minus $100 or $1,900. That is assuming the company went bankrupt and the stock price did an Enron. Thinking about this, if your maximum loss is $1,900 and your maximum gain is $100, why would anyone in their right mind want to use this strategy? Aren't we all taught that you want to use a strategy where your maximum profit is a large multiple of your maximum loss? It's a fair question and now you know the risk of the strategy.

Of course, there are a couple reasons why someone would employ such a strategy. The first one, and the most common, is that people want to gain a little extra income from the stocks they own. Say you have one hundred shares of ABC, a "blue chip" stock. Many people rely on the large, safe company for their quarterly dividend so they can have a little extra income. If ABC is currently trading right around $65 per share, the yield on their dividend is roughly two percent. Obviously, the people who own ABC are hoping for some price appreciation with that dividend, but they're expecting slow, steady growth and are planning on holding onto the stock for a very long time. What if they wanted to increase their annual return in a fairly risk free way? Well, they could write a call option on their one hundred shares. To give you an idea on how that affects their return, a call option that expires in five months from now is trading with a premium of $3.40 per share. If you write two of those per year and add the quarterly dividend to it, you've created a twelve percent return for the year even if the stock price stays at the same level. So, a twelve percent return if the stock price goes nowhere. And that's the great part about covered call writing: anyone can make money when the market is trending up, but it becomes much more difficult when the markets are ranging or staying flat.

Twelve percent. Are you impressed with twelve percent? On a safe stock like ABC? I am. How about another example, maybe something a little riskier? Let's take XYZ. It's trading at $138 per share. A call option that expires five months from now currently has a premium of $15.50 at a strike price of $140. To figure out the percentage yield on this example, you divide the premium by the current price. So in five months you would yield eleven percent. Since it was only for a period of five months it means you can do that twice per year which would yield a total of roughly twenty-two percent.

Before anyone starts getting blinded by the dollar signs, does anyone see the flaws with this plan? Anyone? Time and the break-even point. The two things that are important to every person who plays in the options market. It doesn't matter what side you're on, time and the break-even point affects you. For the person who's trying to generate some decent returns, when they write a covered call they're hoping that the price of the underlying stock either stays flat or goes up. It doesn't matter which, although you will be a little happier if it stays flat because it means you were smart enough to make money without the stock price moving, but it really doesn't matter which one it does. The one thing you don't want to happen when writing a covered call is to have the stock price go down. Sure, you're guaranteed to collect the premium, but the underlying value of the stock that you're holding has now decreased and you could end up with a net loss. And if we remember Warren Buffett's first rule of investing: Don't lose money.

The longer the timeframe, the higher the probability that something will happen to cause the stock price to decrease. And when the stock price decreases, you lose money. So how do you mitigate some of that risk? Simple: shorter time frames. Write a covered call that expires in a month or less. For example, XYZ is trading at $138 right now and the call options that are expiring in a little less than a month are currently trading with a premium of $4.50 per share. If you do the math on that, you'll see that you would yield three percent. Three percent in one month! That's nice. Again, assuming the stock price goes up or stays flat.

Are you impressed with the possible returns? But what must be asked is how much risk you took to get the return. Remember, you had to hold on to a hundred shares of XYZ for an entire year to get that big return. But, what if you write a covered call today with a year holding period and their products become defective, they don't deliver long term performance, or they have another product flop, then the hype and expectation that has helped the price may quickly come tumbling down. And you'll be sitting there holding those one hundred shares. What, you thought this was going to be an easy return may turn out to not be so easy.

After reducing the time risk by writing options that expire in two months or less, the next logical step is to try to mitigate the risk of something bad happening to a company that would cause it to tumble. How do you do it? There are no guarantees, but it is very helpful to know the company that you are owning the shares in. You should know what they do, how well they do it, and be comfortable with the management team. Very basic investing concepts. I don't believe you should purchase a stock, simply because it has high-priced options that you can write covered calls against. Rather, I like buying solid companies and then making timely covered call options.

To help minimize risk, I also like to avoid holding covered calls over a period of time that would include an earnings announcement. The reason is two-fold. First, if the news is bad, I want to be able to sell the stock and not be in situation where I have to deal with the covered call option as well. Second, if the news is good and the stock price jumps, I don't want to have a covered call option in place because the covered call -- as I have described above -- limits my upside gains. Without the covered call in place I can reap the benefits of a jump in the stock's price.

Technical analysis can also help minimize risk. It isn't perfect, nothing is. Nonetheless, there are several rules of thumb that may increase the probability of you being successful with covered call writing. After all, the entire point of trading is to stack as many factors in your favor so the probability of you making money in the long term is as high as possible. To add in those factors besides time risk mitigation and "knowing the company", there are several tools to help you.

The first tool is the use of moving averages. Simple or exponential moving averages both have their pros and cons but the use of either one is straightforward. You have a slow moving average and a fast moving average. The slow moving average is the average closing price every day for a certain number of days. The reason that it's called a slow moving average is because of the larger number of days that are used to create the average and the fact that it adjusts to changes in price more slowly. The fast moving average is the average price of a fewer number of days than the slow moving average. Since there are a smaller number of days that make up the average it will react more quickly to changes in daily price. When the fast moving average crosses over the slow moving average, it generally means that it is a beginning of a trend. Again, simple right? Some people only use moving averages to tell them when to buy the one hundred shares and write a covered call. Other people will throw in other indicators such as relative strength, MACD, Bollinger bands, or any number of other technical indicators that have been developed. I always recommend keeping it simple: only use two or three indicators to tell you when to buy the shares and sell the call. If you develop overly complex systems, you might find that they fit historical data extremely well and would have historically created massive returns, but the risk that you run is that you've created a system that matches the data too closely. By not being robust enough, that perfect system might not work when the market changes. If you keep it simple, you're more likely to find that your system can work in a larger number of market conditions.

So like I said at the beginning: decent returns can be had by employing the covered call writing strategy. That strategy merely consists of buying one hundred shares of a security and subsequently writing a call option with a specific strike price. Simple, right?

Eric Aafedt
President / Founder

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