Option Investor
Educational Article

Covered Calls - Part I

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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
For our example, well say you currently own 1,000 shares of XYZ Corporation trading at $21.30. How you came to own this stock is anybodys guess. Maybe you bought and held, maybe you inherited it, maybe you won the lottery. Its not really important. The question is how can you best use this asset to make money? You have a neutral to bullish outlook on XYZ. You project that it will trade flat or possibly up a little in the next few months. If your projection is just wishful thinking and you have nothing substantial to base your opinion on, you have no business owning a stock, let alone trying to trade options.

Covered Call: The Option
Well, if youve read my previous columns, you know that there is a bottomless pit of speculators out there. Speculators is the nice word. Gamblers is more accurate. There is, and will always be, someone out there who is willing to buy an option betting that JNPR will rise substantially in the next month. He is willing to buy the right to buy XYZ from you at $22.50 anytime between now and July expiration (about 6 weeks). For that right hes willing to pay you $1.50 per share. That translates into $1,500 worth of dead presidents into your pocket.

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
Once youve accepted the possibility that your 1,000 shares may soon leave home, you can focus on the potential profit in the trade. If XYZ finishes above $22.50. There are two ways you will profit.
1) You took $1,500 when you sold the call. Thats a good start.
2) If your stock is called away at $22.50, you will have made another $1,200 in profit from the appreciation of the stock price. Remember, this all started with XYZ trading at $21.30. When the stock is sold, you get the $1,200 difference ($1.20 x 1000 shares).

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
You now know the good. Get ready to learn about the bad and the ugly. The main risk in covered call writing is the fact that you do own the stock. And, contrary to popular optimistic thinking of the masses, the shares of XYZ could go down just as easily as it can go up. The $1.50 taken in from the option purchase provides a little cushion a damn little cushion.

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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.
1) Use a specific dollar stop. Your account management techniques tell you that you have a maximum limit of a $2,000 loss per position. That would dictate that you have to close out your entire position by selling your stock and buy back your short XYZ $22.50 option when it costs you a total of $18.90 ($18,900).

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.

Missed Any Columns?
Hey, this is good stuff - especially if you're serious about learning options. The Pulitzer people won't likely be knocking at my door soon, but I've taught a lot of people how to conservatively and consistently make money - and they're still making money to this day. I hope you'll become one of them.

Who Is This Guy? --
Mike Parnos has "been there and done that" plenty! Mike has been trading, consulting and teaching option strategies for over 12 years. Both individually, and through his writings, Mike specializes in teaching conservative and non-directional option strategies while providing therapeutic guidance to thousands of individuals, brokers and institutional traders. Over the years, he has learned from his mistakes, and the mistakes of others, and he's here to share his wisdom with you. "Trading is as much psychological as it is skill," says Mike. "Keep an open mind. You never know what might find its way in there."
Previous Option 101 Columns

July 19th - What Is An Option?
July 26th - Temptation of Leverage
August 9th - Let's "Put" It Into Perspective
August 16th - The Option Chain Part I
August 31st Readers Q&A
September 7th The Option Chain Part II
September 12th - Option Quiz
September 20th Exercise Cycles
September 28th What You Need To Know About An Option
October 4th Not All Options Are Created Equal
 

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