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Covered-Calls 101

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Covered-Calls 101: Return on Investment and Position Management

This week, we begin another round of Q&A with new subscribers of the Covered-Calls System.

Reader:

Thanks for the info about profit loss calculations and return on investment(ROI).
One thing I'm still confused about: how does the ROI vary with the price of the stock at expiration?

Using the in-the-money ROI example from the CCS website...

(Editor's Note -- Here is the link to the archive mentioned by the reader)

In-the-Money Example:

Buy XYZ stock for $12.00
Sell OCT-$10.00 call for $2.50 per contract
Cost Basis = $12.00 - $2.50 = $9.50
Max Profit = $2.50 - ($12.00 - $10.00) = $0.50
RC = $0.50 / $9.50 = 5.26% (stock unchanged at $12.00)
RNC = RC

What I would like to understand is what happens when the stock moves up or down after the position is established. I know that $9.50 is my break-even point, but what if the stock is at $9.75, $10.75, or $12.75 when the option expires?

For example, if the share value drops to $11.00 (breaking a technical support area I have identified) and I decide to close the position, then I must repurchase the call (for about $1.25 - $1.50?) and sell the stock. But, wouldn't that be a loss even though the stock stayed above the break-even point/cost basis?

Thank You

First, it is very important to remember that an investor who uses the conservative, in-the-money approach to covered-call writing generally views the entire position as a single entity. He is not interested so much in long-term stock ownership or bullish activity, but rather in obtaining a consistent return on investment. He sells in-the-money calls with the expectation they will be assigned and the underlying equity will be "called" away at expiration (because the stock price is above the sold strike price).

With regard to the prices you mentioned, XYZ would be called away at $10.75 and at $12.75. Keep in mind, you sold calls at the $10 strike thus giving the buyer of the options the right to purchase XYZ from you at $10. He would do so because he could sell the stock in the open market at a price greater than $10. Notice the return on investment is the same in both cases because with an in-the-money covered-call, the maximum potential profit is achieved as long as the stock price stays above the sold strike price. All upside movement in the share value of the stock is meaningless, except that it increases the probability of a successful outcome.

If the issue took a bearish turn and the stock price fell to $9.75 at expiration, the sold call would expire worthless (eliminating your obligation) and you would retain the underlying stock. The position would achieve a $0.25 profit, as your cost basis was $9.50 (not including the cost of commissions). At that point, you would have to make a decision: You could sell the stock and take the available profit or transition to a new covered-call position by writing options with a future expiration date. It all depends on your outlook for the stock and the market in general. If you were neutral to bullish on the underlying stock, you might decide to roll-forward (and possibly up), selling new calls in the front month to further lower your cost basis in the shares. You might also decide to keep the stock as a core holding in your long-term portfolio and sell more distant, higher strike options to capitalize on both option premium and stock appreciation. As extended stock ownership is always a possibility, even with ITM covered-calls (especially in bearish market conditions), it is prudent to initiate new positions only with issues you wouldn't mind owning.

If you decided to close the position early, prior to expiration, you would simply repurchase the sold calls and sell the stock. A "net" order could be used when unwinding the covered-write to ensure a proper exit. In that case, you would place an order with your broker to sell the stock and "buy to close" the calls for a specific net credit; a price reasonably close to parity.

Using your example: If you repurchased the calls for $1.50 per contract and sold the stock at $11.00, your net credit would be $9.50 (11.00 - 1.50) per share. With an original cost basis (debit) of $9.50 per share, the end result would be a "wash." Of course, commission expenses would actually make the outcome a small loss but that is part of the overhead inherent to all forms of trading. As far as the cost of the options at the time of repurchase, there are several factors that affect the overall level of option prices: the underlying stock's value, the option's strike price, the number of days remaining until expiration, volatility, interest rates and dividends. It's probably safe to assume the option price would have declined - in relation to the period of time that had elapsed - but just because the price of the stock moves lower doesn't necessarily mean the price of the option will drop accordingly. Understanding this concept (option pricing theory) is one of the keys to successful option trading and the best book on this subject is "Option Volatility & Pricing: Advanced Trading Strategies and Techniques," by Sheldon Natenberg. It is available in the OI bookstore.

Good Luck!

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