Let me begin with a plug; this article is brief and basic. But CallWriter's member site has some great (and free) covered call tutorials for our members. These tutorials offer extensive information and training on covered call writing and covered call strategies better than the information that a lot of websites sell. And for those of you seeking an organized options learning center with tutorials and quizzes that is free, visit The Options Institute at the Chicago Board Options Exchange ("CBOE"): https://www.cboe.com/LearnCenter/cboeeducation/CourseList.html

Getting down to basics...

Options are Contracts, not Equities.
Shares of corporate stock are equity securities that represent an ownership interest in the business forever, or at least until the company goes out of business. Stock options on the other hand are listed securities, but they are derivative securities with a fixed life span, not equities. A company has a fixed number of shares outstanding at any time, but there is no limit to the number of stock options that can be written on shares of that company. The company's stock to which an option relates is known as the underlying stock.

There are two kinds of stock options: CALLS and PUTS. A stock option is a standardized contract that gives the option holder the right to buy (calls) or sell (puts) shares of stock at a specified price for a specified period of time. Each option contract covers 100 shares of stock, so if you want to sell calls on 1,000 shares of stock, you would have to write 10 call contracts. Since an option is a standardized contract, you don't have to negotiate its terms. Except for the underlying stock, the expiration date and strike price, all puts have the same terms and all calls have the same terms.

Example: the CSCO MAR 15 Call is a call option that gives its holder the right to buy 100 shares of Cisco systems, Inc. (CSCO) for a price of $15 per share through the expiration date in March 2003. The CSCO MAR 15 Put gives the holder the right to sell 100 shares of Cisco at $15 per share through expiration.

The Price is Fixed.
The price at which an option can be exercised is known as the STRIKE PRICE. If you hold the CSCO MAR 15 Call, you can buy shares of Cisco through the option's expiration date at $15 per share, no matter what price the stock is then trading. The strike price is fixed and there is no negotiating it. The strike price would only change in the event of a stock split or similar corporate event that requires an adjustment in option strike prices.

Option Transactions.
Just like stocks, stock options have bid and asked prices. The price that is paid for an option is known as the premium. The seller receives the bid price, and the buyer pays the asked price. An option position is opened when it is sold, and the position is closed when the writer buys back options of the same type and class

Option writing.  A person who sells an option (the writer)is said to "write" the option and to be short the option. So the call writer is simply a person who sold call options. The term short options refers to options that have been sold.

Option buying.  A person who buys an option (the holder) is said to "hold" the option and to be long the option. The term long options refers to options that have been purchased.

Stock Options Expire.
The key to stock options is that they have a fixed life, which means that they expire and cease to exist. A stock option that expires without being exercised is said to "expire worthless" - and that about sums it up. Options expire on the third Friday of each month. Expiration is a good thing, though, depending on where you are seated. If you bought a call option that is about to expire worthless, you are about to lose the money you paid for the call; a bummer. But the person who sold the call and pocketed a premium is eagerly awaiting expiration, because it terminates his risk in the call position and locks in his return.

Where's the Money?
Options are valued on several factors, but the two main ones are expiration date and strike price. A CSCO 15 call option that expires in two months has more value and costs more than one expiring this week, obviously; and the call would have even more value if it expires in six months. Strike price is extremely important, also. When Cisco Systems is trading at $14 per share, you would pay more for a call option with a $15 strike than a $25 strike, because the likelihood of Cisco moving above $15 before expiration is far greater than the likelihood of it moving above $25. Depending on where the strike price is in relation to the stock's current price, a call option is either in, at or out of the money:

In the money - the strike price is less than the stock price. [A put strike price is in the money when it is greater than the stock's price.]

At the money - the strike price is the same as the stock's price. An option will be considered to be at the money, however, when the price is close to but not exactly the same as the stock price. For example, a $20 strike price will be considered at the money when the stock is $19.75, even though it is slightly in the money.

Out of the money - the strike price is greater than the stock price. [A put strike price is out of the money when it is less than the stock price.]

Option Exercise.
The call holder exercises his call option by purchasing the underlying shares of stock. The put holder exercises his put option by selling the underlying shares of stock. The holder never has to worry about finding the option seller in order to complete the exercise. The holder simply tells his broker what to do, and the Options Clearing Corporation (OCC) assigns the exercise to someone who was short (wrote) an option of the same type and series (put or call, same underlying stock, same strike and expiration). This is known as assignment. According to CBOE, 10% of options are exercised, 30% of options expire worthless, and 60% are traded out, which means that holders sold their options and writers bought back their options, in order to close the positions. But cut it how you will, options that are traded out to close positions are not exercised, so only 1 of 10 options written gets exercised. When a call writer is assigned a call exercise, he has to deliver the shares, which are said to be "called out" or "called away."

The Covered Call
A call option is considered covered when the call writer owns shares of the underlying stock in a number equal to the number of shares he will have to deliver if the calls are exercised. That is, if the call writer owns 1,000 shares of CSCO and writes 10 CSCO call contracts, the calls are covered by the shares. If the writer should write 15 contracts (1,500 shares), then 10 contracts would be covered and 5 would be naked.

Going Naked.  If you sold calls on a stock you didn't own, the calls would be "naked" and much riskier. Why? Because the stock could advance to a theoretically unlimited price, therefore the risk to the call writer and his brokerage firm) is likewise theoretically unlimited. If the stock moves up substantially before expiration, the call writer might be forced to go into the market and buy the stock at a much higher price in order to deliver it when the call is exercised - and if the stock moves up enough to put the call in the money, it will be exercised. Example, when CSCO is at $14, you write the CSCO $15 Call naked for a $1.00 premium. If the stock moves up to $18 and the option is exercised, you would have to buy it at $18 and deliver it to the call holder at $15, a loss of $2 per share ($15 + $1 - $18).

Some Covered Call Examples.
You buy 1,000 shares of a $20 stock and write the 20 Call option on it for a $2 premium. This transaction puts $2 profit per share in your pocket, for a total of $2,000 (1,000 x $2 = $2,000). Another way to look at it is that the $2 premium reduces your basis in the stock to $18 and therefore protects you against a drop in stock price down to $18. When the option expires, you still own the stock! At expiration, here are your choices:

1) keep the stock and do nothing
2) sell the stock, or
3) write more calls against it

The Monthly Strategy.
On a stock with a stable price, you can fairly safely write an option every month. It is perfectly feasible even in this lousy bull market to make a return of 3-6% monthly (yes, each and every month) by writing covered calls. For example, when CSCO is at $14.30, you write the CSCO FEB 15 Call, which is bid at $.55, meaning you would get $.55 if you sold it now. (Actually you might get slightly more or less, depending on where your sell order gets filled.) This would be a 3.8% return - - not a huge return, but not bad for a 1-month hold, either. So if you bought 1,000 shares of CSCO, you would pay $14,300 and would receive $550 in premium. Upon option expiration in March, you could sell the April call, and in April, you could sell the May call, and so on. That is, you could sell a new batch of calls every month.

Why You Need to Know Where the Highest Returns Are.
But you might not want to keep CSCO and just sell options against it month after month. That is, if the CSCO calls are paying less than 4% but ORCL calls are paying 6%, might it not be wiser to dump the CSCO and buy the ORCL to write covered calls? But how do you find the good option returns? This is the value of our CallWriter Real Time Lists™ - they show you where the highest returns are. The alternative method for finding good covered call candidates would be to find stocks you feel comfortable with, then compute the call returns on them - a lot of work! CallWriter gives you lists of the highest-returning S&P 100, Nasdaq 100 and many other lists (even Deep In the Money and Deep Out of the Money), so depending on your investment philosophy and taste for risk, there is a list that is right for you.

What's that, you say a 3% monthly return is not enough for you?!?!?

A 3% monthly return is over 40% annually, with compounding. 40%! How many money managers and CNBC talking heads do you think are making 40% annually in this bear market? We don't know of a one!

Are Covered Calls Safe?
We don't think of any market investment as safe. If you want safe, put your money into bank certificates of deposit and stay under the $100,000 FDIC coverage limit. But... covered calls are among the safest investments, which is why covered calls are the only option strategy the U.S. Government allows in IRA accounts.

And in Closing...
Well, there are the option basics. Options are a marvelous engine for managing your investments and making regular returns, but only if you start with the best information and make sound decisions. At CallWriter, we give you the best option information on the planet (blush) and give you great covered call picks.

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