When you embark upon your first adventure into options trading, there are those who will tell you that covered call writing is the safest strategy. Even brokerage firms allow novice option traders to trade covered calls in their IRA accounts. Little do they know. Or, if they really do know, little do they care.
Once upon a time there was an investor. All of his life he was taught that, if you buy a stock and hold onto it forever, the stock will go up, you make a lot of money and live happily ever after. Its the American dream. As weve come to learn, those dreams and Mother Goose have a lot in common. Theyre fairytales. The harsh realities of the market have resulted in a rude awakening. The internet bubble, bear markets, and an abundance of corporate improprieties, have systematically demolished hordes of retirement accounts. They buy-and-holders are still holding. Old habits die hard. Only, what theyre holding isnt hard anymore.
Some folks have portfolios of stocks that might like to use a program of selling covered calls to generate some additional income. There are good and bad points to this strategy. Lets start with an overview of covered call writing along with a basic example. Then, well delve into the nitty-gritty of it. There will be two more columns devoted to covered calls.
Covered Call: The Stock
Covered Call: The Option
The speculator is buying the XYZ July $22.50 call option. Hes buying the right, but not the obligation, to buy the stock from you at $22.50. Hes expecting that XYZ is going to appreciate well beyond $22.50. If hes buying the stock at $22.50 and the option costs him $1.50, his breakeven is $24.00.
The nice part about all this is that the $1,500 hes paying you is yours to keep regardless what happens to the stock. It shows up in your brokerage account the very next business day. What you have to be willing to accept is the fact that, if XYZ does happen to move up, youve agreed to sell it at $22.50. You will not participate in any gains above and beyond $22.50. You are trading the upside potential for the immediate, and guaranteed, $1,500. See, everyone has his price.
More Profit Than You Think
You took, in $1,500 from the sale of the option plus another $1,200 profit from the sale of the stock a total of $2,700. Thats a better than 13% return for a little over a month. If you used margin to purchase the stock, it would be about a 26% return.
If, at expiration, XYZ finishes below $22.50, you will still own the 1,000 shares of stock and, if you choose, will be able to sell another call for a future expiration cycle. In an ideal world, you would be able to repeat the strategy month after month. But, as we all know, we do not live in an ideal world.
The Good, The Bad & The Ugly
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The same principles apply to covered call selling as to all other trading and/or investment strategies. The main principle, and the toughest one to live with, is that you must have an established exit point and the self-discipline to act on it when necessary. Of course, that means having to admit that youre wrong when XYZ turns south instead of going up.
How do you figure out your exit point? There are a few ways.
2) Check for support levels. There may be a support level at $20.50. Maybe theres a 50-day moving average at $19.55. You can establish an exit point if one, or both, of these support levels are violated.
For those of you who are chomping at the bit to start trading, hang in there. There is a lot more to know about these covered calls and we will go over it thoroughly in upcoming columns.
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Who Is This Guy? --
July 19th - What Is An Option?