|
March 4, 2003
Some Covered Call Writing Basics
By John Brasher, CallWriter Publisher
| In understanding
stock option basics, I’ve always thought we begin with
covered call writing. It is in many ways easier to understand
(and master) than just buying calls and puts. We’ll
also briefly get into a covered call strategy or two. Whether
you have a lot, a little or no experience with stock options,
this article will help you get a handle on one of the best
option-related strategies out there: covered call writing. |
|
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...
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 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.
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.
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.
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.]
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."
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).
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
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.
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.
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!
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.
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.
|
