Option Investor
Educational Article

Covered Calls II The Realities

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Successful therapy takes hard work. So does becoming a successful trader. Unfortunately, we live in a lazy world. Rather than put forth a little effort, many people hand over life responsibilities and tasks to others then whine like spoiled children when the results arent what they wanted. The path of least resistance isnt like the yellow brick road. It leads to the soup kitchen especially when it comes to taking care of your money.

Last week we discussed the basics of the covered call strategy. Its not rocket science, which means Larry, Moe & Curly can do it. But, theres more to it than meets the eye.

Covered call writing is a popular strategy. Why? Because its pretty simple. You own a stock. You sell someone the right to buy your stock. They give you money. Either the stock goes or it stays. Like I said, pretty simple. You cant lose, right? If you believe that, youre either an idiot or youve been listening to too many old Wade Cook tapes.

What Is A Successful Covered Call?

A successful covered call play results in your stock being called away. Some people really develop an emotion attachment to their stocks. Why? Beats me probably some form of mental illness But, if your stock is called away, dont become depressed. Dont take it personally. You havent been deserted. You shouldnt suffer from separation anxiety. Your stock was a tool something you used to generate a little cash flow nothing more, nothing less.

Cost Basis For 1,000 JNPR Shares: $21,300
Premium Received For Selling $22.50 Call: $1,500 ($1.50 x 1,000)
Shares Called Away @ $22.50
Stock Appreciation (from $21.30 to $22.50) $1,200 ($22,500 - $21,300)
Profit For Option Cycle: $2,700 ($1,500 + $1,200)
Percentage Return for Appx. 1 Month: 12.67%

12.67% is one hell-of-a good return for one month. Just think, if you buy the shares on margin (dont even think about it), your return would be over 25% for the month. The numbers above represent a best case scenario. Thats if everything goes just right. But, we know better than that, DONT WE???!!!

You shouldnt sell covered calls on stocks that you dont want to have called away. Does that stop traders from selling calls on their favorite stocks? Of course not. When their precious stock is trading above the strike price of the short call, what can they do besides panic, of course?

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Rocking & Rolling

If you believe your sold covered call is at risk of being exercised, you can buy the call back and roll it out for another month or two to a higher strike price. This, in effect, buys you more time and frees up the stock for more dollars of appreciation.

Using our previous JNPR example, lets say you sold the near term JNPR $22.50 call for $1,500. The stock has moved to $24 and you believe its going to continue higher without you participating. The problem is that youve capped your potential profit when you sold the $22.50 covered call. With a few weeks left to expiration, there will still be some time value left (about $.50) in the $22.50 call along with the intrinsic value ($1.50). It might cost you $2.00 to buy back the option and free up your stock. Youve just added $2.00 to your cost basis, but your shares of JNPR are free to run to the moon without any encumbrances.

Another alternative is for you to look at the next months JNPR (July) option chain and see that the $27.50 call is selling for $.50. You could sell the July $27.50 call and take in the $.50, thereby covering the extra $.50 of time value you spent to buy back the June $22.50 call.

So, lets do the math. You just paid $2.00 to buy back the $22.50 call. Now youre selling the $27.50 call for the following month for $.50. That means you are still $1.50 out of pocket ($2.00 less $.50). But, are you really out of pocket? JNPR is now trading at $24 that is $1.50 above the $22.50 strike price. Basically, what youve done is to add $1.50 to your cost basis for the stock. But, now JNPR can move up to $27.50 and you will participate up to that level.

Looking back at last weeks column, we see that the original cost basis for your shares of JNPR was $21.30. Now, it is $22.80 ($21.30 plus $1.50). Again, the $1.50 comes from the $1.50 that JNPR is trading above the $22.50 strike price, plus the $.50 you received for selling the $27.50 call and minus the $.50 of time value you paid for when buying back the original $22.50 call.

When selling the $27.50 call, you would again be taking on an obligation to sell your JNPR shares this time at $27.50 in about six weeks. As JNPR continues to move up, you can repeat the process. Additional option premium may not always be there, but at least youll still own your precious stock.

A Marriage Made In . . . ?

Fact: Most brokerage firms allow covered-call selling in IRAs. Fact: There are still countless buy and holders who are still holding stocks in their IRA. Its fate. Its inevitable that the twain will meet. The money or the stocks will eventually disappear and the novice traders will have more bad things to say about options. They will continue to live in denial. It wasnt their fault. Theyll blame the options -- when they simply dont know how to use them. When all is said and done, the only way to own a stock is to buy a protective put as insurance to protect against catastrophic events. Check out one of our previous therapy sessions in which we discuss the collar in great detail.

Who Is This Guy? --

Mike Parnos has "been there and done that" - plenty! Known as the MasterTater and "Options Therapist," Mike has been writing the profitable and popular Couch Potato Trader column (for OptionInvestor.com) for almost five years. Hes 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.

For serious traders, Mike offers a comprehensive two-day seminar covering many fascinating and profitable non-directional strategies. Feel free to send questions and/or comments to mparnos@optioninvestor.com.

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."

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