Covered
calls actually are very simple. A covered call
is just a simple combination of two things: buying
shares of stock and selling call options
on those shares.
The
point of a covered call, which I'll explain in
more detail below, is to generate an income of
3% to 5% each and every month.
First,
let me briefly explain stock options,
how they are used and why you want to sell
them - not buy them.
What
is a stock
option?
A
stock option (also known as an "equity"
option) gives its holder the RIGHT, but no obligation,
to either BUY or SELL 100 shares of a specific
company's stock (ex: Apple), for a specified
time period, at a specified
price (the "strike price"
or "exercise price").
There
are only two types of stock options:
• Call option (or just
"call")
• Put Option (or just
"put")
Call
- holder has the right, but no obligation, to
BUY the underlying shares.
Put
- holder has the right, but no obligation, to
SELL the underlying shares.
A
stock represents a share of equity ownership
in the company. Stock options, however, are standardized
contracts that trade on exchanges
just like stocks.Options have a limited life and
eventually expire; stocks do
not.
The
key to understanding
stock options...
Being
standardized contracts, all stock options are
identical in every respect, except
for four things:
1.
Whether it is a put or call;
2. Underlying company (ex: Apple)
3. Strike (exercise) price
4. Expiration date
If
a stock option is not exercised by its expiration
date, it ceases to exist and expires
worthless - its holder then loses
the price paid for the option.
Call
options generally are very cheap compared to buying
the stock itself.
EX:
when Apple is $56/share, the Apple current-month
60 call (right to buy Apple at $60 for 30 days)
might cost $3.25.
Buying
a call option gives you control of the
underlying shares of stock through the call's
expiration - because you can buy the shares at
the call's exercise price during the option's
life (or not) at your sole election.
How
do stock option prices move - and
why?
When
the underlying stock price rises, the value of
calls goes up; the value of the puts goes down.
The
value of calls on a stock moves WITH the stock,
up or down.
When
the underlying stock price falls, the value of
calls goes down; the value of the puts rises.
The
value of puts on a stock moves opposite
to the stock.
Buying
stock options creates leverage...
Option
Leverage:
Buy
100 shares APPL at $56
=
$5,600.00
-
OR -
Buy
1 Dec $60 APPL Call ($3.25
x 100 Shares)
=
$325.00
Look
at what options do:
they createleverage.
For a price of $3.25 a share, a trader could buy
APPL call options and control as many shares as
desired until the calls expire.
The
option buyer would pay $325 per call option
contract, instead of $5,600 to buy 100
shares of AAPL. This is what speculators do. It
can be profitable, but it's risky. Remember, the
call buyer doesn't own the stock, only a wasting
asset.
Here's
a quick example...
Suppose
Apple (AAPL) is now $56/share but we think it
will rise quickly on an earnings report. We could
buy the stock for $56, but a
mere 100 shares of Apple would cost us $5,600.
And if Apple should sell off, we could lose a
lot of money.
But
let's say we could instead buy the current $60
call (the right for one month to buy the stock
at $60) for only $3.25 per share.
One call contract covering 100 shares of Apple
would only cost $325.
Risk:
If Apple should sell off, we could lose a lot
of money. A fall of 10% would cost us $560, and
a 20% fall would cost us $1,120! But
- if we instead buy the $60 call, the most we
could lose is the $325 in premium paid for the
call. We might not lose the entire $325, but that
is our worst-case loss scenario.
Lucky
us!
We guessed correctly, and in a couple of weeks,
Apple went up $8 in price, to $64. Our 60C did
not go up the same amount (that rarely happens),
but it did rise to $5.50.
Our
alternatives:
1.
Exercise call and sell stock for a profit;
2. Sell call for a profit
Here
is our profit if we sell the call for $5.50:
Profit
= $225.00 (5.50 - 3.25) x 100
One
who bought the stock made $800 ($100 x $8), a
nice14% return on $5,600. On the other hand, one
who instead bought the call made a profit of $225
on a $325 investment, a 69% return!
Isn't
buying options for speculation
kind of risky?
Yes,
buying options to speculate on stock price movement
is quite risky!
First,
the call buyer doesn't own the stock, only a wasting
asset (one that expires).
Call-Buying
Risk
Percentage
of options actually exercised
=
10%
Percentage
traded out or that expire worthless
=
90%
Third,
you must guess right about the stock's expected price
movement. If the price doesn't go up, the call expires
worthless.
Fourth,
even if you're right about the coming price movement,
you must have the timing of it right. If the
miss the timing, you lose. (It is much easier to get
the direction right than the timing.)
According
to the CBOE, only 10% of all call options bought
are ever exercised. This means that 90% of all
calls are either traded out or expire worthless - not
good odds for speculators!
Speculators
point out that when buying options you can only lose
the option premium wagered. But small or not, isn't
that a 100% loss? That 10% average win rate isn't
very good for the call buyer. But these 90/10 odds are
terrific odds for those who sell calls, known as call
writers.
Selling
naked calls - they're
really risky.
When
you don't own the stock underlying the call, your obligation
to deliver the stock is not covered (thus, naked)
in the event the calls are exercised.
Remember,
when you sell calls, you may be required to deliver
the underlying shares at the exercise price.
If the calls
are exercised but you don't own the stock, you will
have to buy the stock in the open market order to deliver
it.
Naked
Call: Suppose
you sold that $60 Call option on shares of AAPL, and
then AAPL went rose tor $70 by expiration. You would
take losses, because someone holding the December
60 Calls would certainly exercise them.
You
would have to go into the market and buy the stock
at a price of $70 or more, but you'd have to sell
them at $60 when the calls, the exercise price. Ouch!
Selling
"naked" calls is extremely risky!
is
there a conservative way to sell
calls?
Since
the odds are that only 10% of calls will ever be exercised,
then the odds are 90-to-10 across the board in
the call seller's favor.
Since
naked calls are so risky, you might wonder
- can calls be sold without such huge risk? Is is possible
to write (sell) call options in a way that is conservative?
YES - there
is a way to sell call options very conservatively (the
CBOE says it's more conservative than just owning stock).
And now,
you are about to learn the secret.
Covered
Calls: the secret to low-risk
income.
In
writing a covered call, the trader sells the call options
but also buys the underlying stock. By purchasing
the stock at the same time, the trader's obligation
to deliver the shares is completely covered. Let's look
at the AAPL trade if it was done instead as a covered
call...
Covered
Call: AAPL
Buy
100 shares APPL at $56
=
$5600.00
AND
Sell
Dec $60 APPL Calls ($3.00 x 100 Shares)
=
$300.00
Trade
sets up a 5.6%
return in 30 days!
(300.00/5300.00 = 5.6%)
The
writer would buy 100 shares of AAPL for every call option
sold. So if a trader wanted to write 5 call options, it
is necessary to buy 500 shares of the stock. Suppose we
wanted to write 1 covered call contract on AAPL by selling
the $60 Calls for a premium (price) of $3.00 per share?
By writing
the $60 calls for $3.00/share in call premium, the covered
call writer:
pulled
in $300 of income (potential 5.6% return),
reduced his basis in the stock from $56 to $53 ($5,600),
lowered his risk in the trade at the outset,
and was never naked on the calls written.
So unless the stock went below the $53 breakeven point,
the covered writer could not take a loss.
A
simple covered call example, an Apple
trade This is why
we write covered calls!
If
at expiration of the $60 Calls, AAPL was trading above
$60, the calls would be exercised.
Completed
Covered Call: AAPL
Bought
100 shares AAPL ($56)
=
$5600.00
Sold
1 Dec $60 APPL Call ($2.00)
=
$300.00
Sold
100 Shares APPL ($60)
=
$6000.00
Return
(30 Days)
=
$700.00
Final
return for 30 days is 13.2%
That equates to a
158% annual return!
(700.00/5300.00 =13.2%)
The
covered call writer already pocketed the $3.00/share
premium when the trade was run. This is income.
But - the
covered call writer sold the AAPL shares at $60 and
also picked up a $4.00 profit above the $56 paid.
Now look at the total return to the covered call writer:
$300
Call premium
+
$400 Profit on
sale of AAPL shares
=
$700
Total profit
The
price of AAPL stock had to move up for the stock
buyer to profit. For the call buyer
to profit, the stock also had to move up - and
do it by option expiration day. Good luck!
But
the covered call writer made an income off the stock
from trade open.
Speculate
in options if you want excitement... But if you want conservative
income, write covered calls!
We are NOT against speculation
in options. Even the dullest gambler guesses right occasionally,
thus option buyers win big sometimes. And it is
these speculators, after all, who buy all these overpriced
call options from us.
But
the covered call writer pockets that fat call premium,
no matter what happens!
Covered call
writing can provide a consistent monthly income.
It's like forcing a stock to pay you a fat dividend.
Now
you can see why we like covered calls so much: they
provide income,
they involve no speculation,
and they're one of the most
conservative strategies out there.
